Beating the S&P 500

It's January! Time to see how your portfolio fared against the S&P 500 over the past year. For 2006, the benchmark index had a total return of 15.8%. That's more than 10 percentage points greater than the 2005 total return of 4.9% and well above the historic average, which is just north of 10%. Anyone who follows mutual funds probably knows that legendary fund manager Bill Miller, after 15 consecutive years of beating the S&P 500, finished 2006 nearly 10 percentage points behind the index.

OK, then. Get out your year-end statements and do the numbers.

Winning with diversification
If you want to beat the S&P 500 year after year, you've got to think outside the box -- specifically outside the box of 500 U.S. large-cap stocks. The key to winning big is to diversify, which guarantees you a share of the winners. No one wants to be stuck with a lopsided portfolio weighted down with losers.

To ensure broad participation, a well-diversified equities strategy should include four dimensions:

1. Asset type: growth stocks, value stocks, and those that blend the two categories.
2. Industry: basic materials, consumer cyclicals, consumer staples, energy, financials, health care, REITs, utilities, etc.
3. Capitalization: large cap, mid cap, small cap.
4. Geography: U.S., Europe, Asia/Pacific, and emerging markets.

Of course, anyone who invests mainly in an S&P 500 index is diversified across asset type and industry. But because the companies are all U.S. large-cap stocks, diversification by capitalization and geography is totally missing.

The international factor
In the first issue of the new Motley Fool Global Gains international investing service, advisor Bill Mann opened with a pop quiz: "Companies domiciled outside the United States represent what percentage of total world market capitalization? Could it be 20%? Or 35%? The stunning answer is 51%. That's right. More than half of the world spins on an economic axis outside the United States."

Some investors argue that they get enough international exposure by investing in U.S. large-cap stocks with significant international sales -- Coca-Cola (NYSE:KO), Microsoft (NASDAQ:MSFT), and General Electric (NYSE:GE) are three that fit that profile. True, companies like these do make substantial revenues from customers abroad. But restricting your investing along these lines constitutes very limited participation in the global economy. Compare the performance of the Dow, with its preponderance of global companies, with virtually any of the international indexes, and you'll see the fallacy of this logic. Over the past five years, the Dow has averaged around 4% annual gains. Over the same period, the Morgan Stanley EAFE Index (EAFE stands for "Europe, Australasia, and Far East") has returned more than 14%, and the red-hot Morgan Stanley Emerging Market Latin America Index has averaged more than 25% per year!

The United States may still be the 500-pound gorilla in the world's zoo, but there are now plenty of other big animals that merit an investor's attention.

Diversification with multiple indexing
My favorite way to achieve broad diversification is with a portfolio of complementary indexes. The table below shows how you could have done investing this way and buying a range of U.S. large- and small-cap stocks (value-weighted), international stocks, and REITs.

As the table shows, this indexing strategy has substantially outperformed the S&P index over one, three, and five years. Of course, past performance is no guarantee of future results, but this sort of diversification has been an effective means of hedging your investment bets. The 25% international exposure in this portfolio might seem uncomfortably high to investors schooled in the "10% foreign" rule of thumb. If you're of that mind-set, then Jeremy Siegel's recommendation of a 40% international stake in his book The Future for Investors will be even more startling.

What about individual stocks?
A thoughtful mix of index funds is an excellent strategy to achieve long-term investment success. It also offers an elegant way to balance a portfolio of individual stocks for overall diversification. For example, I tend to favor large-cap value stocks that pay dividends such as Pfizer (NYSE:PFE), ConocoPhillips (NYSE:COP), and Bank of America (NYSE:BAC), to mention a few of my individual stock holdings. But I maintain diversification by boosting my small-cap index allocations accordingly.

Foolish bottom line
If you want to increase your chance of beating the S&P 500 year after year, one good way is to broaden your investment choices to include a generous mix of smaller caps and a healthy helping of international equities. Index mutual funds and ETFs offer an easy means to get that degree of breadth. On the other hand, if you limit your investment choices to the S&P 500, then you're unlikely to fare any better than the 75% of fund managers who routinely fail to beat the index.

To learn more about international investing, take a look at our Global Gains service free for 30 days. Or you can subscribe today and profit from two valuable new reports: "3 International Small Caps Set to Dominate Overseas" and "Global Investing Secrets -- 3 Things You Must Know Before Investing a Dime Overseas." Click here to learn more.

Fool contributor Doug Short owns shares of Bank of America, ConocoPhillips, Coca-Cola, Microsoft, and Pfizer. Coke, Microsoft, and Pfizer are Inside Value recommendations. Bank of America is an Income Investor pick. The Motley Fool has an ironclad disclosure policy.