How to invest when you are broke?

How do you start investing if you're barely scraping by?

Say you're making $25,000 a year and know that (along with feeding yourself, paying for gas, rent, etc.) you need to start thinking about your future.

It pays to do that, because even small amounts add up surprisingly fast if you invest on a regular basis. And Uncle Sam will even kick in free money on top of that.

For instance, over the past 10 years, the stock market, at least as measured by the S&P 500 Index ($INX), has returned around 8%, on average, annually. Say you start with nothing and invest only $10 per week. If you pick an investment that only matches the S&P's 8% return, after 10 years, you'd have around $8,000. You have $10,000 if you got lucky and picked an investment that churned out 12% average annual returns.

Even better, if you're a poor person, the government rewards you by refunding as much as half of what you put in. Singles earning up to $15,000, head of households earning up to $22,500 and married joint filers earning up to $30,000 get a credit of 50% of funds contributed to an IRA or 401(k). That means, for instance, if you invested $1,000 in your 401(k) last year and qualified for the credit, your refund would be $500 larger. (A dedicated saver could turn right back around and plow that $500 into a Roth IRA as well.)

One big caveat: Investing in small amounts isn't about investing in individual stocks. All stock investors, no matter how talented, eventually pick a clunker, a stock that drops 25% or 30% before your first cup of coffee in the morning. That's not so bad if you own 20 stocks. But it would be a disaster if you hold only four or five.

Instead, mutual funds and exchange-traded funds make more sense for small investors. Richard Jenkins, editor-in-chief of MSN Money, explains here how to use ETFs. Below, I'll explain how to get started using mutual funds.

Why funds?

For starters, mutual funds give you automatic diversification. Most hold dozens, if not hundreds, of stocks. So, when one goes south, its impact on the portfolio is minimal.

Also, fund managers have advantages over individual investors. It's their day job, and because their trading generates huge commissions, they have access to better information than individual investors.

The problem for small investors is that most mutual funds don't want your money. Why? Simple: Funds get paid by taking a percentage of their investors' money in the form of management fees. It costs them just about as much money to keep track of your account and send you monthly statements as its does for some fat cat that's plunking down $100,000 at a whack.

So most funds establish minimum investing amounts that preclude small investors. Many require you to invest at least $3,000 to open an account, and many ask for much more.

Fortunately, I found a few fund companies (called fund families) that believe the story about small acorns leading to big trees and do welcome beginning investors.

By the way, you have to buy these funds directly from the fund company. Purchasing funds via stockbrokers, even the deep discount types, doesn't work for small investors. Most ask for a substantial check to open accounts. But, that's not a problem. The funds I'm going to describe all accept investments from individuals.

About loads

Before I get into the details, I need to tell you about the difference between load and no-load funds.

Originally, all mutual funds were sold through full-service stockbrokers and financial advisers. Those folks have to get paid, and their commissions are called "loads." Then, in the 1950s, funds that marketed directly to investors began to appear. Since there was no middleman involved, there was no need for the loads, hence the name "no-load" funds.

Loads typically run close to 6% and considerably reduce your return on investment. While it makes sense to pay for good advice, I'm going to show you how to pick your own funds. So there's no point in paying a load.

Automatic payment is key

Only a few fund companies cater to small investors, and for those, agreeing to an automatic investment plan is the key that opens the fund-investing door.

Automatic investing means that you agree to invest a fixed minimum amount every month. However, simply promising doesn't cut it. You have to give the fund company permission to deduct the agreed amount from your bank account.

Each company has its own rules about how much it takes to start a fixed investment plan, and the required monthly investment.

Here's a list of the fund companies I found that accept small investors, and their rules.

Amana funds

Minimum initial investment: $250

Minimum monthly investment: $25

Amana operates two funds, Amana Trust Growth (AMAGX) and Amana Trust Income (AMANX), that invest according to Islamic principles. The funds avoid investing in businesses such as liquor, pornography, gambling and banks. Since collecting interest is prohibited, Amana funds avoid bonds and other fixed-income securities.

Hodges Fund

Minimum initial investment: $250

Minimum monthly investment: $50

Hodges operates a single fund, called simply Hodges Fund (HDPMX).

Steward funds

(formerly Capstone Funds)

Minimum initial investment: $25

Minimum monthly investment: $25

Steward operates four stock and two bond funds following biblical principals and consistent with a Christian lifestyle. The funds avoid investing in companies materially involved in pornography, abortion, alcohol, gambling or tobacco.

Minimum initial investment: $100

Minimum monthly investment: $100

Originally serving only teachers and other public employees, TIAA-CREF operates five stock mutual funds that are open to all investors. Finding them on TIAA-CREF's site is more than a little tricky. From TIAA-CREF's home page, select Fund Research, and then Mutual Funds. Then scroll past Retail Mutual Funds to Retail Class -- Institutional Mutual Funds.

Picking the best funds

Not all funds are created equal, and just because a fund will take your money doesn't make it a good investment. Below are a few measures that will help you pick the best funds. You can do most of your research right here on MSN Money.

Morningstar star rating

Morningstar rates funds by comparing each fund's historical returns (gains) to its historical volatility. The ratings range from one to five stars, where five is best.

Returns reflect how much money you would have made holding the fund for a specific period. Volatility is a measure of how much the fund's share price bounced around along the way. Morningstar's star rating compares each fund's historical returns to it historical volatility. The funds with the highest return to volatility ratios get the highest ratings.

While history is no guarantee, I've found that fund managers with a strong record of outperforming the market tend to continue their winning ways. Start with five-star rated funds. If you find your list is too narrow, consider adding four-star funds, too.

Morningstar risk rating

Risk is the enemy of all investors, small or large. So, I'm going to advise you to check risk two ways, starting with Morningstar's risk rating.

As I mentioned above, Morningstar's overall star rating compares return to volatility. A shortfall of that gauge is that volatile funds can still get high scores if their returns are high enough. By checking Morningstar's risk rating separately, you can rule out funds in that category.

Morningstar separates funds into five risk categories: low, below average, average, above average and high. Avoid "above average" and "high" risk funds.

Standard deviation

Morningstar's risk rating compares a fund's volatility to other funds in its same category (e.g. small-value, banks, tech stocks, etc.). So if a fund is in a volatile category, say technology, Morningstar might rate it as low-risk even though it's risky on an absolute basis.

Standard deviation is similar to Morningstar's risk rating, except it measures historical volatility on absolute basis. By adding standard deviation to the mix, you can rule out Morningstar low-risk-rated funds when they are, in fact, risky.

Standard deviation values run from as low as one to as high as 30 and sometimes higher. The higher the number, the riskier the fund. In my experience, it's best to rule out funds with values above 20.

Most of the fund companies catering to small investors operate only a few funds, so you can check the Morningstar ratings and standard deviation on MSN Money's Fund Portfolio report as I've done here for Vanguard 500 Index (VFINX). As you build your nest egg, diversify your money across different funds to decrease the chance of losing money if one fund happens to go sour.