The 2-Stock Strategy That Destroyed the Market

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There's a two-stock portfolio that handily beat the market over the past decade with virtually the same volatility -- in fact, it experienced fewer 10% monthly losses than the S&P 500 did during that period. In my opinion, there's also a pretty good likelihood that the same portfolio will beat the market over the next decade (but not by the same margin). Thinking through this strategy will help you to see the goal of beating the market in a different light, particularly if you invest in or want to invest in high-growth stocks.

Violating finance theory for fun and profits
Much higher returns with similar volatility? That would appear to violate standard finance theory, according to which higher returns require higher risk. Here's the trick: One of the two stocks is the market: an index ETF such as the State Street SPDR S&P 500 ETF (NYS: SPY) or the Vanguard S&P 500 ETF (NYS: VOO) . The other stock is Apple (NAS: AAPL) , the 800-pound gorilla that is the fruit of the union between an electronics whiz and a lifestyle guru. I'm not going to teach you anything by telling you that you would have done very well if you had owned Apple shares over the past 10 years, but what may surprise you is the impact that kind of performance can have on total portfolio returns over time.

I ran the numbers on a portfolio initiated on Jan. 31, 2002, with a 95% weighting in the S&P 500 and a 5% position in Apple. Over that period, a $10,000 investment in the SPDR S&P 500 ETF would have grown to $13,998 for a meager 3.5% annualized return (Vanguard's ETF didn't exist in 2002). This "Apple-juiced" portfolio, on the other hand, weighed in at $31,765 for a highly satisfactory 12.3% average return.

The Apple-juiced portfolio
Adding Apple juice to the portfolio made a huge difference -- nearly $14,000 worth on an initial $10,000 investment, and the volatility of the portfolio wasn't much higher than that of the index portfolio. One immediate objection to this strategy is the discomfort the rapidly ballooning exposure to Apple would cause most investors. In four years, the Apple position went from 5% to one-fifth of the total portfolio value; at the end of the 10-year period, the figure was close to 60%.

There is a compromise strategy that addresses that concern: rebalancing the portfolio to the original weights on an annual basis, such that at the end of every calendar year, Apple once again represents 5% of the portfolio. That strategy, "Apple-light" if you will, grew the original $10,000 to $20,495 -- less impressive than the Apple-juiced portfolio, certainly, but still way ahead of the index portfolio.

The ripe fruit of exponential growth
Let me be clear: The same Apple-juiced and Apple-light portfolios will not achieve that margin of outperformance over the next 10 years -- that's an absolute certainty. It took an extraordinary 43.5% average return over 10 years to achieve the feat once. If Apple grew at the same rate for another 10 years, it would tip the scale at more than $17 trillion in market value. (For comparison, the 2010 U.S. gross domestic product in 2010 was $14.6 trillion.) However, with a P/E under 12 -- and that figure doesn't account for the cash on its balance sheet -- the odds look very good that it will beat the S&P 500 again -- P/E: 12.9. (Senior technology analyst Eric Bleeker explains why Apple is still a compelling buy at $500.)

Getting overweight on an Apple
To beat the market, you don't have to reinvent the wheel by building a portfolio from scratch. Instead, you can have the bulk of your portfolio in an index fund and overweight one or a few stocks that you select for their potential to beat the market. What do I mean by "overweight"? Let's consider the Apple-juiced portfolio for illustration. The SPDR S&P 500 ETF already contains Apple; in fact, with at an index weight of approximately 3.8% as of last Monday's close, it's the largest component. By adding "standalone" Apple shares to an index fund portfolio, we're overweighting Apple relative to the index.

If your goal is to beat the market by more than a modest amount, you'll need to focus the non-index component of your portfolio on companies that you believe have exceptional growth prospects; as we saw earlier, these stocks can have a major impact on portfolio returns.

A smarter way to bet on growth
If I wanted to invest in very high-growth stocks, that's the way I'd tackle it: own a limited exposure to a set of these companies in a portfolio anchored by index funds. That gives you the opportunity for market-throttling returns with a maximum downside that you are comfortable with at the outset (in the event that all the individual stocks went to zero). I don't invest that way, because I don't think I am skilled at identifying that category of stocks -- it's a very difficult thing to do.

If you are looking for stocks that will play the same role that Apple played in some investors' portfolios, you'll certainly want to read this report from a team with a good record in this area which identifies one potential candidate.

At the time this article was published Fool contributorAlex Dumortierholds no position in any company mentioned. Check out hisholdings and a short bio. You can follow himon Twitter. The Motley Fool owns shares of Apple and has sold shares of SPDR S&P 500 short.Motley Fool newsletter serviceshave recommended buying shares of and creating a bull call spread position in Apple. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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