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When it comes to stocks, there is a cohort of investors who are big believers in only buying index funds. Other investors strongly believe that individual stocks are the way to go. Where do I stand on the issue? I think that an optimal diversified portfolio will have a combination of both.

As I mention in The Insider's Guide to Income Investing (free PDF; email address required), from my perspective, the primary purpose of allocating money to broader-market indices "is to ensure that the correlation between your equity portfolio and the broader-market remains no lower than a minimum acceptable level." It's quite easy to create a diversified allocation to individual stocks that will experience rising yields on cost over time. But investors should not ignore the risk that the wrong mix of individual stocks will underperform, from a total return perspective, over extended periods of time.

Perhaps over the very long term, pretty much any diversified mix of blue chips will perform in line with broader-market averages. But as I remind investors in the aforementioned guide, "While it has been historically true that stocks outperform other asset classes over very long periods of time, it is important to remember that each of us has very defined time horizons." I continued, "In other words, even though stocks may outperform other asset classes over time, you might run out of time before that happens."

Even though the following five stocks would likely pass the "Am I Diversified?" test on Jim Cramer's "Mad Money," an investor owning them would have underperformed the S&P 500 (NYSEARCA:SPY) in a major way over the past couple of years. Which stocks am I referring to? They are International Business Machines (NYSE:IBM), McDonald's (NYSE:MCD), Exxon Mobil (NYSE:XOM), The Coca-Cola Company (NYSE:KO), and Southern Company (NYSE:SO). Over the past two years, IBM and Southern are even down on a price basis. McDonald's hasn't fared all that much better. Exxon Mobil has performed okay but still dramatically worse than the S&P 500. The Coca-Cola Company has done quite well, with double-digit annualized total returns over the past two years. But even Coke couldn't keep even with the S&P 500.

Naturally, I expect some readers to immediately say, "But you're just cherry picking certain companies." It is true that I selected five widely-owned, well-known businesses out of scores of widely-owned, well-known businesses. But the purpose of my choosing those five stocks was not to pick on them specifically. Instead, I want to illustrate that it is indeed possible to purchase a group of stocks that receive plenty of "Buy" recommendations, are usually highly regarded, and are generally expected to keep up with broader gains in the market, and still underperform by a wide margin over an extended period of time.

In this case, I am not talking about a couple of months but rather a couple of years. And who knows for how much longer that underperformance will continue. My concern is that these are the exact type of stocks many investors have been flocking to as the hunt for yield, dividend growth, and perceived stability dominated the equity investing environment in recent years.

If it pleases readers, however, I can extend this list to other large-cap stocks as well as a few industry-specific ETFs. It's been a brutal two years for Exelon (NYSE:EXC) shareholders. Freeport-McMoRan Copper & Gold (NYSE:FCX) is also down over the past two years. And Rio Tinto (NYSE:RIO) and Caterpillar (NYSE:CAT) have gone virtually nowhere in two years. Perhaps an investor wanted to diversify into the Market Vectors Agribusiness ETF (NYSEARCA:MOO) to gain exposure to the global agribusiness industry. That ETF would have helped an investor diversify. But it wouldn't have helped an investor keep up with the S&P 500. Moving along, I hesitate to even mention the Market Vectors Gold Miners ETF (NYSEARCA:GDX) because those shareholders have experienced enough pain without being reminded of their massive unrealized losses. Last but certainly not least, even the iShares U.S. Real Estate ETF (NYSEARCA:IYR) has failed to keep up with the S&P 500. Though it did come a lot closer on a total return basis than the other stocks and ETFs previously mentioned.

To summarize, an investor owning a diversified portfolio including any or all of the following 12 stocks and ETFs would have underperformed the S&P 500 over the past two years: IBM, McDonald's, Exxon Mobil, The Coca-Cola Company, Southern Company, Exelon, Freeport-McMoRan Copper & Gold, Rio Tinto, Caterpillar, the Market Vectors Agribusiness ETF, the Market Vectors Gold Miners ETF, and the iShares U.S. Real Estate ETF.

And I am certain there are others I could add to this list, if I spent some more time searching.

I am not trying to scare anyone away from investing in individual stocks. At this time, I own 20 individual stocks in my portfolio, which, fortunately, as a collective group, have performed up to expectations over the past two years (Rio Tinto notwithstanding). Nevertheless, I recognize the possibility that there could come a lengthy period of time during which the group of stocks I own fail to keep up with broader-market indices. And it is for that reason that I think properly diversifying within an equity allocation includes having a portion of the allocation dedicated to broader-market indices.

Source: Diversifying Your Stock Portfolio - How You Do It Matters

Additional disclosure: I am long Exelon, Rio Tinto, and Phelps Dodge (FCX) bonds.