How to invest your next $1,000

By Harry Domash

Have you noticed that when the market tanks, seasoned investors such as Warren Buffett, instead of selling, wade in looking for bargains?

They probably figure that in the future, we'll recognize that this summer's market volatility was a buying opportunity. But what if you're not Warren Buffett? Say you only have $1,000 to invest?

If you're in that boat, don't even think about individual stocks. Even great stock pickers come up with their share of duds. You need to own at least 10 stocks to keep one clunker from sinking your portfolio returns. You can't do that with $1,000.

Your best approach is to put that $1,000 in an old-fashioned managed mutual fund. Traditional managed funds aren't as fashionable as the new kid on the block, exchange-traded funds, but they are a better fit. Most ETFs track indexes that reflect the action of a particular market segment. To use them effectively, you have to successfully predict which sectors are going to outperform over your investment horizon, say the next 12 months. That is harder than it looks.

By contrast, mutual-fund managers can adjust their portfolios as needed to reflect market conditions.

Below, I'll show you how to spot low-risk funds likely to outperform the overall market. That's already a rare combination, but finding funds that fit that bill and also welcome small investors is about as easy as turning a triple play in baseball.

However, with the aid of MSN Money's Deluxe Screener, I was able to turn up 8 worthwhile candidates. Here's how I did it.

Suitable for small investors?

I started by defining a universe of funds suitable for small investors.

Open to new customers: Some funds, especially those specializing in small companies, stop accepting new investors when they think that they already have as much money as they can wisely invest, so there's no point to including them in the results.

Screening parameter: Closed to New Investors = false

Open to small investors: Since the bookkeeping and customer-support costs are basically the same regardless of account size, many funds establish relatively high minimum opening balances to avoid dealing with small investors. This screening parameter rules out funds that won't accept $1,000 initial investments.

Screening parameter: Minimum Initial Purchase <= $1,000

Special purpose not: The screener database lists some funds with $0 minimum initial purchase requirements. These are, in fact, available only via special purchase plans, such as plans for college students. I eliminate them here.

Screening parameter: Minimum Initial Purchase >= $1

Institutions only: Some funds cater to pension plans, trust funds and other institutional investors, and don't want individual investors. This factor rules them out.

Screening parameter: Institutional Investors = false

Say no to loads: Many fund operators rely on financial advisers and stockbrokers to market their funds. They collect special fees, called "loads," to compensate the adviser or broker for recommending their funds. Front loads are paid when you purchase and deferred loads are paid when you sell. Most load funds charge one or the other, not both.

Since the loads are marketing expenses, there is no point in paying them if you're picking funds on your own.

Screening parameter: Front Load = zero

Screening parameter: Deferred Sales Charge = zero

The screener sometimes lists funds that pass all of the above tests but are available only through financial advisers. To rule them out, I require that passing funds must be available through Charles Schwab's retail network. I'm not necessarily recommending purchasing through Schwab, but of the available broker choices in the screener, Schwab offers the biggest fund selection.

Screening parameter: Brokerage Availability = Schwab Retail

Stocks, not bonds

Some mutual funds invest mainly in bonds instead of stocks. Bonds may or may not have a place in your portfolio. But, today, we're looking for stock funds. However, because some stock funds hold bonds to reduce risk, I allow at least 20% bond holdings.

Screening parameter: Percent Stocks >= 80

Out of 5,000 or so mutual funds, only 195 passed those tests. Next, we'll pick the low-risk funds with the best price-appreciation prospects from that list.

Go with the best stock pickers

As is the case for practically every endeavor in life, some fund managers are better stock pickers than others. While this is a controversial topic, I've found, assuming that the same manager is at the helm, a fund with a strong historical track record is likely to outperform funds that have lagged the market, at least over the next year or so.

To find those managers, I required a minimum 17% average annual return over the past three years. By comparison, the overall market, at least as measured by the S&P 500 Index ($INX)

has averaged a 12.5% or so annual return over the same period.

Screening parameter: 3-Year annualized Return >= 17

Expert help

Morningstar rates funds by comparing their historical returns to volatility, which is a risk measure. Morningstar rates funds from one to five stars, where five is best. Funds with the highest return-to-volatility ratio within the same category (e.g. small-cap growth) get the highest ratings.

While Morningstar's ratings aren't perfect, as was the case with three-year returns, they are a good place to start. I've had the best results sticking with four- and five-star-rated funds.

Screening parameter: Morningstar Rating >= 4 stars

Continued: Volatility is not your friend

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