This Could Help You Beat the Market

Never put all of your eggs into one basket. Don't hide all of your cash under one mattress. And if you're fully invested in gold, by all means, don't bury it all in one treasure chest. The fundamentals of diversification are simple: Spread risk across several assets, and unforeseen setbacks won't clean out your coffers.

Stock portfolio diversification for retail investors has been revolutionized by exchange-traded funds (ETFs). These modern innovations of finance take entire indexes and combine them into one stock. So if mom and pop want a portfolio that mimics the S&P 500, the SPDR ETF makes it easy to buy shares and rebalance portfolios without having to buy shares of 500 separate companies.

Out with the old
SPDRs, though, have an inherent weakness: Like the indexes they track, they are market-cap weighted, which means they invest more money in the biggest stocks. In other words, a megacap like Exxon Mobil (NYSE:XOM) carries a heck of a lot more weight than a mid-cap like Ciena, even though you'll find both in the S&P 500 index.

The problem with this weighting scheme is that the smallest companies can often be the biggest winners, since they have more room to grow.

But there's a way around this problem. Another index strategy simply invests equal amounts in every stock in an index, regardless of their relative size. That prevents small companies' gains from being eclipsed by the movements of behemoth stocks.

A better way
One fund that uses this equal-weight strategy is the Rydex S&P Equal-Weight ETF. This ETF treats NVIDIA's (NASDAQ:NVDA) gains and losses no differently than those of Microsoft (NYSE:MSFT). Thus, it captures the upside potential of smaller stocks, while avoiding an overemphasis on big stocks. Over the past five years, the Rydex ETF has returned 2.9% annually, handily beating the S&P's 0.7% average annual return.

To really understand what's going on, you can drill down on the individual sectors and really see the nuts and bolts.

Unfortunately, Rydex has only offered its sector-specific ETFs since November 2006, so we can't go back a full five years. But it's still interesting to compare 34-month returns of its equal-weighted funds with those of the market-weighted SPDRs:

Source: Yahoo Finance. Returns from Nov. 7, 2006 to Sept. 17, 2009. Equal-weight returns based on Rydex sector ETFs; cap-weighted returns based on SPDR sector ETFs.

Since November 2006, the equal-weight ETFs have beaten the market-weight ETFs in all but two sectors. This suggests that there may be an easy way for retail investors to beat the market.

Is smaller better?
Of course, this strategy won't work all the time. Sometimes, large-cap stocks outperform smaller stocks, in which case a cap-weighted strategy will do better than an equal-weight strategy. Yet some older equal-weight mutual funds have long-term track records of a decade or more of consistent outperformance.

Certainly right now, the strategy has done well. If you look at the stocks that have earned top returns in the S&P 500 this year, you'll find that many of them are the smaller components. Meanwhile, losses for former mega-cap stocks like Citigroup (NYSE:C) and AIG (NYSE:AIG) had a much softer impact on the Rydex equal-weight fund than they did on the SPDR. At the same time, the Rydex fund captured the gains of small stocks like Watson Pharmaceuticals, which the SPDR all but ignored.

There's definitely a place for large-cap stocks in your portfolio. Yet basing your entire investing strategy on current market capitalization seems arbitrary and may not be the best way to allocate your money. And while big companies like Procter & Gamble (NYSE:PG) and Wal-Mart (NYSE:WMT) could keep producing profits for decades to come, they've already had their day in the high-growth sun.

To diversify your stock portfolio, seriously consider buying an equal-weight fund. It's a quick and easy way to boost your exposure to small- and mid-cap stocks, and if the past is any indicator, you won't regret your purchase.