The Large-Cap Basket Case

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There's definitely a case to be made for investing the bulk of your retirement portfolio in large-cap stocks. Large caps -- the stocks of huge, established companies, with market values solidly the billions -- offer some distinct advantages over other investments:

• They tend to be less volatile than smaller stocks during periods of market turbulence;
• Their near-term prospects tend to be more predictable than those of smaller companies;
• They often pay dividends.

With the bumpy market ride we've had over the last several months, the case for large caps has seemed particularly strong. Several readers have told me that they're "rotating out" of smaller caps, putting their retirement portfolio into dividend-paying large caps. Plenty of others, of course, have been there all along, having put their retirement nest eggs into an S&P 500 index fund.

But here's the thing: If you're looking to beat the market, consistently and over the long term, large caps alone aren't the best bet.

More baskets, happier eggs
As baskets go, large cap stocks are a pretty good one. But having all your eggs in one basket -- any basket -- leaves you exposed when the basket, er, market, drops.

While household names like ExxonMobil (NYSE: XOM), Procter & Gamble (NYSE: PG) General Electric (NYSE: GE), and Bank of America (NYSE: BAC) -- all among the biggest 10 stocks in the S&P 500 -- may seem like relatively good long-term investments, odds are high that they'll drop along with the rest of the market during the next downturn. And while they might not lose as much value as smaller-cap stocks, they're also unlikely to shoot up as dramatically as small caps during the early stages of the following bull market.

It's just the nature of the investing universe -- different segments of the market behave differently. You can leverage this to your benefit with diversification, the practice of spreading your assets out among those different segments. (Learn more here.) Done right, diversification allows you to take advantage of the strengths of different asset classes while limiting your exposure to each asset's weakness. It can reduce your downside risk while actually increasing your returns over time.

Of course, actually putting together a diversified portfolio can be tricky, if you don't understand how the different asset classes behave relative to one another.

Finding the right baskets
In this month's issue of the Fool's Rule Your Retirement newsletter, available today, lead analyst Robert Brokamp takes a long look at how different asset classes behave relative to large-cap U.S. stocks. In his article, Brokamp focuses on correlation, the degree to which various asset classes "zig and zag" in unison -- or not -- with large-caps over time.

As it turns out, the correlations of the major asset classes to U.S. large-caps are fairly predictable -- small caps are fairly well-correlated, international stocks and REITs less so, and bonds and commodities not much at all. No surprises there. But how can we use that information to improve our portfolios?

Obviously, investors seeking higher returns will invest more aggressively, looking to asset classes such as small-caps and emerging-market stocks. Those worried about volatility will instead seek out investments like bonds, which tend to be more stable over time. But getting down into the nuts and bolts of what you should do in your specific situation is a more complicated exercise, one that requires some understanding of why the different asset classes behave the way they do. Brokamp's article walks through this question, looking at the major asset classes in some detail, and offering straightforward recommendations you can use to simply and effectively tailor your own investment strategy.

If you'd like to read the full article, help yourself to a complimentary one-month guest pass to Rule Your Retirement. The pass will give you full access to today's new issue and dozens of back issues covering all sorts of retirement questions. You'll also be able to participate in a special members-only discussion board for your questions and ideas -- and have access to a unique set of planning tools to help you create your own plan for retirement. It's all yours for 30 days, with absolutely no obligation to subscribe.