Over the long term, stocks outperform bonds and bonds outperform cash, which was affirmed in 2010. Analyzing the breakdown of asset categories will help you craft portfolios that will perform best in this new year and beyond.

Fees matter. The S&P 500 finished up 15.06% for 2010. Your index fund probably underperformed this benchmark by whatever expenses the fund incurred. If your fund is very efficient, this amount was small. But if your funds fees are excessive, your performance was reduced even more.

For every additional 1% you earn over your working career, you can retire seven years earlier or 50% richer, a huge effect. In the financial world, a single percentage point is broken into hundredths of a percent. Each hundredth is called a “basis point,” abbreviated “bps,” and pronounced “bips” in financial parlance. Saving just 15 bps in expenses during your working career allows you to retire a year earlier, a dramatic advantage. That’s how important fees are.

Compare your funds to the iShares S&P 500 Index ETF (IVV). It returned 14.97% with an expense ratio of only 0.09%. See if excessive fees are reducing your returns.

Stocks on average beat bonds, and bonds are more complex than stocks. Last year followed this trend. The Barclays Capital U.S. 1-3 Year Treasury Bond Index finished the year with a meager gain of 2.40%.

The expense ratio on iShares Barclays 1-3 Year Treasury Bond ETF (SHY) is 0.15%, which means you are charged more for investing in short-term bonds. Bond investing is more intricate than stock investing. Every share of Apple stock is exactly the same, but every bond’s unique characteristics must be evaluated. No bond index fund can perfectly track the index, so they approximate the index and either over- or underperform. This year iShares SHY returned 2.22%, slightly underperforming its benchmark minus its expense ratio.

Setting the right benchmark matters. A fair benchmark for your portfolio is a combination of the S&P 500 for your equities and 1-3 year Treasury bonds for your fixed income. Blend these two indexes according to how much you have in appreciation and stability. For example, an investor with 70% of her portfolio in equities and 30% in fixed-income would calculate her benchmark index as 0.7(15.06) + 0.3(2.40), or 11.26% for all of 2010. Knowing your benchmark return keeps you from being satisfied with an 8% return when at this level of risk you should have had an 11.26% return.

Risk is usually rewarded. For the past two years, appreciating assets have done better than stable fixed-income investments. In 2008, however, risk was severely punished. Equities return an average of 6.5% over inflation, and fixed-income returns 3% over inflation. So when inflation averages 4.5%, equities average 11% and bonds average 7.5%. In 2010, inflation was only about 1.1%.

Diversification means putting money in equity investments that ought to do better than the S&P 500 with reasonable risk and in fixed-income investments that are liable to do better than the 1-3 Treasuries with reasonable risk. Against these two benchmarks you can compare the plethora of other indexes.

Knowing which indexes are worth an allocation is critical. The thousands of different indexes each have their own return. The S&P 500, a large-cap U.S. stock index, is only one subsector of one of our six asset categories. Over the past decade, nearly every other subsector or asset class has done better than the S&P 500.

Let’s begin by looking at subsectors with U.S. stocks. One way to divide U.S. stocks is using the style boxes popularized by Morningstar. The vertical axis on the 3 by 3 Morningstar grid represents size, from large-cap at the top to small-cap at the bottom. The horizontal axis represents value on the left to growth on the right.

Generally small-cap stocks do better than large-cap stocks. This year was no exception. The Russell 2000 Small Cap Index returned 26.85% versus the S&P 500’s 15.06%. Your investments should include a healthy share of mid- and small-cap stocks even if they are more volatile.

Generally value stocks do better than growth stocks. This year that truism was mixed. Large-cap value beat large-cap growth. But in mid- and small-cap, growth performed better. Tilting value is recommended in every market except a roaring bull market. If your crystal ball doesn’t forecast that clearly, we recommend maintaining a continuous value tilt.

In the United States, emphasize technology. Another method to divide the U.S. stock market is by sector of the economy. Information technology, the largest sector, comprises 18.4% of the economy. It includes Apple, Microsoft, IBM, and Intel. The subsectors have all done well, with hardware up 23.36% and software up 22.64%.

This is what we do best. Our government now heavily regulates the financial, health and energy sectors. That’s 39% of our economy. How can our banking industry compete globally with heavy regulation and a corporate tax rate of 35% when Hong Kong or Singapore has all the safeguards needed and a corporate tax rate of 10% or 17%, respectively? You don’t want your investments dragged down by a lack of economic freedom. So overemphasize those sectors left free to innovate and compete on the global market.

Although technology is the historically highest performing sector of our economy, it also has the highest volatility. Interestingly enough, health care has been the second-highest performing sector but with much less volatility. Not so this year. In 2010 health care was the second-worst performing sector behind utilities, returning only 6.49%. The Patient Protection and Affordable Care Act, aka Obamacare, has begun to affect that sector of the economy negatively. Construction on doctor-owned hospitals has halted. Insurance rates are up. My own High Deductible Health Plan (HDHP) is no longer available to the public. My personal coverage will continue as long as I don’t change any of the terms. So much for freedom and choice. In light of increased socialization, my standard advice to emphasize health care has to be reevaluated.

These eight observations should help you improve your U.S. stock returns. Next week we will look at the lesson to be learned from looking at last year’s returns on foreign investments.

Photo by Chris Lawton on Unsplash