Two-minute takeaway

  • Pundit prognostications aside, mean-reversion is more or less a fact of investing life.
  • Smart portfolios, therefore, are smartly diversified, with an emphasis on quality names that span the market's cap ranges and valuation spectrum because ...
  • ... when growth stocks (for example) fall from favor, your value picks can help cushion your portfolio's blow.
  • Don't be an "accidental" investor. Know how your lineup is allocated and ensure that your next stock purchases add value at the level of portfolio construction, too.

I'm an inveterate number cruncher, but it's important to resist the temptation of false precision: Statistics are easily manipulated, after all, and sometimes we see patterns where none exist. This point was brought home for me -- literally -- while reading the children's classic The Phantom Tollbooth to my daughter, Penny Lou.

Traveling from Dictionopolis (whose nonsensical, language-besotted citizens have no use for numbers) to Digitopolis (where only numbers matter), the book's hero, Milo, seeks to rescue Rhyme and Reason, twin princesses whose imprisonment years ago caused the municipal divide and condemned each land to lack, well, rhyme and reason.

In trying to explain the usefulness of averages to Milo, for example, a not-fully formed boy who represents the 0.58 portion of the 2.58 children typical in Digitopolis families observes:

[I]f you didn't have any money at all but you happened to be with four other people who had ten dollars apiece, then you'd each have an average of eight dollars. ... [Think] how much better off you'd be, just because of averages.

A second example featuring a farmer whose situation is similarly "improved" during a drought by average rainfall follows.

Kid lit says the darnedest things
And so it is with the facts and figures with which we investors contend, including the widely held beliefs that, over time, small caps always trump large-cap stocks, and that value beats growth.

Recent history would seem to confirm these beliefs. Since their inception in May 2000, for example, the iShares Russell 1000 Value (IWD) tracker -- home to the dirt cheap likes of Chevron (NYSE:CVX) and Merck (NYSE:MRK) -- has trumped its iShares Russell 1000 Growth (IWF) counterpart, an ETF whose top holdings include Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), a pair of aces with double-digit earnings growth prospects as far as the eye can see.  

Similarly, the iShares Russell 1000 (IWB) ETF -- home to buttoned-down behemoths like Procter & Gamble (NYSE:PG) and Coke (NYSE:KO) -- has lagged its smaller iShares Russell 2000 (IWM) sibling, a fund whose top holding -- Human Genome Sciences  (NASDAQ:HGSI) -- has sprinted to a gain of more than 1,300% year to date.

And yet ...
We shouldn't, however, let what behavioral finance researchers call "recency bias" cloud our vision.

As Freud purportedly once said, sometimes a cigar is just a cigar. And as Vanguard founder Jack Bogle has shown, these small-cap and value truisms are more -isms than truth, owing, it turns out, to exceedingly thin slivers of time. Carving out just a few years from the market's historical track record reveals that mean reversion -- not inherent asset-class superiority -- is the fact of investing life.

Put another way -- and to quote The Phantom Tollbooth's Milo -- "[A]verages aren't real. ... They're just imaginary."

Rhyme, reason, and Foolishness
Armed with a healthy dose of skepticism, you can build and maintain a thoughtful portfolio, and if you'd like some assistance on that front, snag a risk-free guest pass to the Fool's flagship Stock Advisor service here. Presided over by Tom and David Gardner, the friendly rivalry at the center of the service has yielded a wide-ranging list of recommendations, a group of stocks from which you can cherry-pick as you assemble a well-diversified portfolio.

Diversification is only as helpful as your stock picks are strong, of course, and the brothers' picks have been strong indeed: David's side of the scorecard has sailed past the market's average by some 68 percentage points while Tom's side is up by 37 points.

Click here to check out the complete list -- for free -- and to snag a sneak peek at the 10 stocks the Fool's co-founders consider their "best buys now."

Apple is a Motley Fool Stock Advisor pick. Google is a Motley Fool Rule Breakers recommendation. Procter & Gamble is a Motley Fool Income Investor pick and the Fool owns shares of it. Coca-Cola is a pick of both Inside Value and Income Investor.  

Shannon Zimmerman runs point on the Fool's Duke Street and Ready-Made Millionaire services, and he runs off at the mouth each week on Motley Fool Money, the Fool's fast 'n' furious podcast. He doesn't own any of the companies mentioned. You can check out the Fool's strict disclosure policy right here.