Another Simple Way to Beat the Market

Last Updated May 25, 2010 6:56 PM EDT

On Wednesday, we discussed how tilting your portfolio to small-cap and value stocks can improve its expected return. Today, we'll discuss another way to potentially boost your returns.

There's another simple strategy to beat the market available to all investors -- diversification. For the period 1970-2009, the S&P 500 Index returned 9.9 percent per year. During the same period, the MSCI EAFE Index (an index of large-cap stocks from the developed countries of Europe, Australasia and the Far East) returned 9.5 percent per year. A portfolio diversified across both asset classes would have outperformed either index. For example, a portfolio that was 50 percent S&P 500/50 percent EAFE would have returned 10.3 percent per year.

The two strategies -- investing in higher returning asset classes and diversification across asset classes -- can be combined. For example, consider the period 1970-2009. The S&P 500 returned 9.9 percent per year with a standard deviation of 18.1 percent. On the other hand, an annually rebalanced portfolio with an allocation of 12.5 percent each in the S&P 500, U.S. small-cap stocks (represented by the Fama/French US Small Neutral Research Index), U.S. large-cap value stocks (represented by the Fama/French US Large Value Research Index) and U.S. small-cap value stocks (represented by the Fama/French US Small Value Research Index), and 50 percent in the EAFE would have returned 11.9 percent per year with a standard deviation of 18.7 percent per year. Returns increased a relative 20 percent while volatility increased just 3 percent.

Again, you would have had your discipline tested. For example, for the period 1995-99, the S&P 500 outperformed the diversified portfolio by 10.9 percent per year (28.6 versus 17.7).

The strategies to outperform the market are quite simple. First, you have to abandon hope of outperforming through the use of exciting (but likely to be disappointing) active strategies (stock selection and market timing). Instead, you should diversify across asset classes (using passively managed funds) that provide the desired exposure to each asset class. And you must have the discipline to stay the course, rebalancing as necessary.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.