Don't Buy the S&P 500

Did I just write that headline?

After all, I firmly believe that most people should index most of their money. But I also believe that the market is inefficient and can be beaten.

Holding the line
The strength and weakness of S&P 500 index funds (or any index funds, for that matter) is that they hold a broad range of companies without any active management. A well-balanced basket of indexes keeps your portfolio out of trouble, but also precludes you from market-beating returns.

Not beating the market is the best reason to consider another strategy -- but it isn't the only one. By its very nature, an index fund invests in a broad range of companies -- some of which you may not want to own. Take a look at some of the S&P 500's top holdings.

Are you comfortable?
You probably noticed Citigroup and AIG on the list. Did you wince? They're not the only prominent financial companies in the S&P 500 -- even after the precipitous drop in financials' stock prices, the sector makes up 14% of the S&P 500. Do you believe financials are undervalued and will turn around, or do you believe the credit crisis still has legs?

Energy stocks comprise another 14% of the S&P 500. Is the oil boom a bubble or the beginning of a long-term trend?

And what about Google and Apple? Will they continue to innovate and justify their sky-high valuations, or are they poised for the fall former stock market darling Starbucks recently experienced?

Buying the index means you're exposed to sectors and companies you might want to avoid -- and limited in your exposure to sectors and companies you think will take off. And in either case, you're limited to the market's returns.

The better way
If throttling the market is your goal -- and it should be -- you need to buy individual stocks -- and you need a way to separate the winners from the losers.

A recent Ned Davis research study demonstrated that S&P 500 stocks that paid dividends returned 10.1% annually from 1972 to 2006, compared with 4.1% for the non-dividend payers. That's a six-percentage-point advantage just by separating the dividend payers from the non-dividend payers!

Of the 500 stocks in the index, 384 currently pay dividends -- giving you a wide range from which to choose. To pick the cream of the dividend-paying crop, look for:

• Management teams that are aligned with long-term shareholder interests,
• Strong competitive advantages, and
• Solid financials.

The Foolish bottom line
Investing in the S&P 500 ensures that you don't lose to the market -- but it doesn't let you win, either. The dividend-paying portion of the index, however, can give you a leg up.

If you want a cheat sheet of dividend stock ideas, our team at Motley Fool Income Investor just reviewed the more than 75 stocks on its scorecard. You can see its best stock ideas for new money completely free with a 30-day trial -- just click here to get started. There's no obligation to subscribe.

Anand Chokkavelu owns shares of Citigroup but none of the other companies mentioned. Wal-Mart, Intel, and Starbucks are Motley Fool Inside Value selections. Google is a Rule Breakers pick. Apple and Starbucks are Stock Advisor recommendations. The Motley Fool owns shares of Starbucks. The Fool has a disclosure policy.