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)
Bank of America
Bank of New York Mellon
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.