Juicing the Market's Returns

Beating the market's annual average by just a percentage point or two can mean a great deal of money over the long term. As an example, let's consider an investor who contributes $2,500 a year to his IRA and earns 10% annually -- roughly the market's average return over the past several decades. He would accumulate $452,359 after 30 years. But boosting that average by 2% jacks the total up to $675,732. In this case, two percentage points translates into well over $200,000.

Here, then, is a relatively low-risk method that attempts to add those precious few percentage points to the market's average: "Index Plus a Few." Former Fool writer Matt Richey expounded on this five years ago, dubbing it the "IPF" strategy. In a nutshell, this elegant and simple plan gives investors a very good shot at market-beating returns over the years.

Index ...
It all starts with allocating the majority of your portfolio -- 70% to 90%, say -- to an S&P 500 or total-market index. You can do this two ways. The first is to buy into an index fund, such as the Vanguard S&P 500 Index (FUND:VFINX) or a similar total-market fund.

But perhaps an easier way is through an exchange-traded fund (ETF). These can be bought and sold just like stocks through your online discount broker. The two ETFs we're interested in here are S&P 500 Unit Depositary Receipts (AMEX:SPY) -- better known as "Spyders" -- and Vanguard Total Stock Market Index VIPERs (AMEX:VTI). One tracks the S&P 500, the other the total market. Either, or both, will work just fine.

Investors with the bulk of their portfolio in any combination of these instruments are already off to a great start. They stand a good chance of outperforming the majority of managed mutual funds over the years. If this is you, and this is as far as you want to dip your toe into the equity markets, that's fine by us. But if you want to shoot for higher returns while adding just a bit more risk, read on.

... Plus a few
And now for the part of the equation we're counting on to help us beat the market averages over time. And we're talking about only a few stocks that will fill out the remaining 10% to 30% of our ports -- stocks that will provide the extra boost we're seeking. The following examples may seem extreme, but selecting just one such winner during your lifetime can make up for a lot of mediocre or poor investments:

All returns dividend- and split-adjusted.

But how do you find such stocks before they rocket in value? You can search on your own, or with help from others. Either way is fine. In fact, even though I've been a guest analyst for our Motley Fool Hidden Gems small-cap newsletter, I'd be happy if your skills have evolved to where you can do most of the work yourself. And since we're talking about investing in just a few companies with this strategy, you need a deep understanding of your stocks that will only grow as the years roll by.

At the same time, I know that plenty of you would like help finding "the few," and I'm more than comfortable guiding you to Hidden Gems, where Tom Gardner and his guest analysts have rolled up 31% average returns since the product's inception in July 2003. That stacks up very well to the 10% return for similar amounts invested in the S&P 500. I also think that investing in a few smaller businesses is a nice complement to the indexes, which are dominated by larger companies.

Start right now
If you're interested in this strategy, you'll want to get into an index first. The larger the percentage of your portfolio that you allocate to an index, the less risk you'll take on. Cautious investors may even want to start with 95% in the index, leaving 5% for individual stocks. Younger and more experienced investors can shift the allocation to take on more risk in exchange for potentially more reward.

The next step, of course, is finding your few stocks. If you're going on your own, there's a wealth of information out there that you can dive into -- most of it right here at Fool.com. If you like the idea of a newsletter with two specific recommendations each month, you can give Hidden Gems a try, for free, for 30 days. Click here to get started.

No matter how you decide to do it, the most important thing is to simply get started.

This article was originally published on Jan. 26, 2005. It has been updated.

Rex Moore helps Tom Gardner pan for gold at Hidden Gems. He owns no companies mentioned in this column. Biogen Idec is a Motley Fool Stock Advisor recommendation. The Motley Fool is investorswriting for investors.