Competing With the S&P 500

Come January, Fools ask themselves how their portfolios have stacked up against the S&P 500 over the past year. Anyone who follows mutual funds might look to Legg Mason's Bill Miller for inspiration, given that Miller has extended his winning streak to 15 years. That's impressive, even if the index's 2005 total return of 4.91% wasn't an especially challenging target for investors who broadly diversify their assets. In fact, a 4.91% return beat inflation by only about 1.5 percentage points.

The key to winning big is to diversify.

Winning with diversification
The usual rationale for diversification is to reduce risk by spreading it around. At the simplest level, diversification means balancing stocks (equities) and bonds (fixed-income investments) in some ratio. If you skew the balance toward stocks, you increase the risk of volatility and periods of negative return. But if you skew the balance toward bonds, you increase the risk that inflation will reduce the value of your portfolio, even though the dollar amount may continue to grow.

However, an equally important rationale for diversification is to guarantee a share of the winners. No one wants to be stuck with a lopsided portfolio weighted down with losers. To ensure your broad participation in the market, a well-diversified equities strategy should include four dimensions:

• Asset Type: aggressive growth, growth, growth and income, income
• Capitalization (for stocks or stock funds): large-cap, mid-cap, small-cap
• Industry: e.g., basic materials, consumer cyclicals, consumer staples, energy, financials, health, REITs, utilities
• Geography: U.S., Europe, Asia/Pacific, emerging markets

Of course, anyone who invests mainly in an S&P 500 index is diversified across asset types and industries, but the companies are all U.S. large-cap stocks. As this table shows, over the past five years, mid- and small-cap indexes have dramatically outperformed the Dow and the S&P 500.

Data from Morningstar; current as of 1/18/06.

If your investment dance card has excluded the smaller caps, then you've missed out on some major fun!

The international factor
A compelling reason for diversifying beyond the U.S. market is the globalization of just about everything these days. In 1980, U.S.-domiciled businesses accounted for 62% of the world economy. Now, 26 years later, such businesses make up a smaller 50% of the world economy, and the downward trend shows no sign of reversing. Take a look at the performance of some of the key Morgan Stanley Capital International (MSCI) indexes over the past five years for a striking contrast with the major U.S. indexes.

Data from Morningstar; current as of 1/18/06.

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), General Electric (NYSE:GE), and the like. True, companies of this sort do make substantial revenues from customers abroad. But restricting your investing along these lines constitutes a limited participation in the global economy. Compare the performance of the Dow, and its preponderance of global companies, with virtually any of the international indexes, and you'll see the fallacy of this view. The U.S. may still be the 500-pound gorilla in the world's zoo, but there are now plenty of other big animals that also merit an investor's attention.

Broad diversification with indexing
Index funds provide an easy way to achieve broad equity diversification. In his book The Four Pillars of Investing, William Bernstein offers a number of excellent examples of indexing via Vanguard funds. The table below shows his most diversified example -- one that incorporates U.S. large- and small-cap stocks (value-weighted), international stocks, REITs, and even a small amount of precious metals.

Annual total return data from Vanguard.

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 22% international exposure in this portfolio might seem uncomfortably high to investors schooled in the "10% foreign" rule of thumb. If you're of that mindset, then Jeremy Siegel's recommendation of a 40% international stake in his book The Future for Investors will be even more startling.

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 international equities. 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 S&P 500 stocks, then you're unlikely to fare any better than the 80%-plus of fund managers who routinely fail to beat the index.

If you're interested in taking small-cap investing to the next level, take a look at the Motley Fool Hidden Gems newsletter. You'll get access to 50 recommendations and all of the research behind them, along with community discussion on each pick. Take a free trial to check it out today.

Coca-Cola and Microsoft are Motley Fool Inside Value recommendations.

Fool contributorDoug Short is a big-pharma IT manager who spent most of his spare time last year earning the designation of "Accredited Asset Management Specialist" from the College of Financial Planning. You can reach him at [email protected]. Doug owns shares of Coca-Cola and Microsoft. Click hereto see The Motley Fool's disclosure policy.