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You can beat the market by stock picking without paying any attention to asset allocation, but you must be willing to experience periods -- they may be long -- of significant underperformance. A strategy that combines stock picking with some basic asset allocation considerations can also outperform, but with lower volatility. That's critical because lower volatility makes it much easier for investors to remain disciplined and focused on the long term. Below, I'll illustrate the process.

Asset allocation matters
Let's consider market capitalization. Small-cap stocks beat stocks with the largest capitalization in the previous decade ended Dec. 31, 2010, by a full 6 percentage points on an annualized basis. I'm using the Russell 200 and the Russell 2000 (small-cap) indexes here. Strictly speaking, the Russell 200 reflects the performance of the "largest cap segment of the U.S. equity universe." I'll refer to this group as "large caps" for convenience.

Is small caps' reign over?
Small caps can't sustain that kind of outperformance forever -- if they could, they'd all be large caps. (Warning: The following sentence contains a piece of financial jargon.) Returns, like valuations, are mean-reverting -- periods of above-average returns are followed by periods of below-average returns and vice-versa. Small caps have had a long run, but this may be about to change -- durably. Large caps are ready to depose them; they proved that during the third quarter, beating small caps by 9%.

I can't tell you exactly when the "change in power" will occur, but I can tell you with total confidence that it will occur. Right now, you should be overweight large caps and underweight small caps if you want to be on the right side of history and earn the best returns.

Drilling down to find seven stocks
Of the largest capitalization stocks, which ones will benefit most? Based on a straightforward screen, the seven stocks in the table below look like excellent candidates. They're among the worst-performing stocks in the S&P 500 over the past decade (bottom quintile) -- all other things equal, they should rebound highest. 


How Did the Stock Perform Relative to the S&P 500 During the Prior Decade? (annualized basis)

Cisco Systems (Nasdaq: CSCO  ) (7.6%)
General Electric (NYSE: GE  ) (7.8%)
Dell (Nasdaq: DELL  ) (3.9%)
EMC (NYSE: EMC  ) (11.3%)
Ford Motor (NYSE: F  ) (2.6%)
Bank of America (NYSE: BAC  ) (3.1%)
Bank of New York Mellon (NYSE: BK  ) (5.1%)

Sources: Author and S&P Capital IQ.

Is each or even any one of these stocks certain to outperform the market over the next five to 10 years? Certainly not, but all are reasonably likely to do so. The odds for the whole basket to outperform are even better, and if we continue adding similar stocks, the odds of outperformance also rise. However, the margin by which we can expect to beat the market falls and at some point, we own the whole segment, and we're back to a pure asset allocation strategy.

Asset allocation + stock picking = great success!
To increase your odds of success while keeping your portfolio to a manageable number of stocks, you'll need to supplement your top-down analysis with bottom-up, fundamental analysis (stock picking). Early on, I referred to the assumption that "all other things equal;" that's rarely the case when you're comparing individual stocks. Unfortunately, stock picking is very hard -- much harder than the simple observations I made above.

Your next step
That's where Million Dollar Portfolio advisor Ron Gross can help. A former hedge fund manager, he has the experience and knowledge for the job. A stock picker by inclination, he nevertheless doesn't ignore asset allocation. In fact, the guidelines of the real-money portfolio he manages ensure it because he's picking the best stocks from across the full range of different Motley Fool newsletter services. If you'd like to find out about more about five stocks Ron owns in the portfolio -- stocks that remain actionable ideas today -- just click here and we'll send you Ron's free report, "5 Stocks for the Next Bull Market."

Editor’s Note: A previous version of this article listed some erroneous price multiple information. The Motley Fool regrets the error.

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Ford Motor, EMC, Cisco Systems, and Bank of America. Motley Fool newsletter services have recommended buying shares of Ford Motor, Dell, and Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 28, 2011, at 5:57 PM, xetn wrote:

    I'm curious about all the growth predictions I keep hearing about.

    Example: The S&P ended 2000 at 1320.28 and on 10/21/2011 at 1238.25. In just over ten years and 9 months, we have managed to lose almost 7%. At the same time, we have lost over 31% of the purchasing power of the US dollar. In other words, we have lost almost 40% in that time period.


  • Report this Comment On October 28, 2011, at 6:15 PM, Frankydontfailme wrote:

    Short all except emc and csco

  • Report this Comment On October 29, 2011, at 11:37 AM, kdt34wqx wrote:

    GE has been underperforming (for good reason) since 1999 (12 years) with no upside in sight. I think I'll skip the history lesson and stay short on GE. This article is complete nonsense.

  • Report this Comment On October 29, 2011, at 7:00 PM, Frankydontfailme wrote:

    Well the big cap versus small cap part makes sense kdt

  • Report this Comment On October 29, 2011, at 7:43 PM, mhonarvar wrote:

    so because these stocks did poorly over the last 10+ years..they will outperform the next 10....good luck with that.

  • Report this Comment On October 30, 2011, at 1:21 AM, constructive wrote:

    "They're also in the bottom quintile with regard to their forward price-to-earnings ratio -- another positive indicator for future performance."

    There's no way a forward P/E of 15 is in the bottom quintile.

    Also, EMC's forward P/E is not 11.

  • Report this Comment On October 30, 2011, at 2:13 PM, constructive wrote:

    Also, BAC did not perform -3.1% annualized relative to the S&P 500 the last decade. It performed much worse, losing ~75% of its value.

  • Report this Comment On October 30, 2011, at 10:11 PM, Pawn49 wrote:

    I have to wonder if the 2 2 3 4 5 still holds and if so, why invest in any of these stocks? Just someone asking a Foolish question.

  • Report this Comment On October 30, 2011, at 11:05 PM, constructive wrote:

    russ, TMF abandoned the Foolish Four strategy a little over a decade ago:

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