In case you were in a comaduring 2008, I have the sad task of bringing you up to speed on one of the worst years for investors since the Dark Ages. If, on the other hand, you were up and moving around during 2008, you likely would have preferred to be in a coma.

How bad was it? Well, that really depends on what your portfolio contained. If you owned only bonds and cash, you probably had the last laugh. In fact, cash trumped all the major U.S. equity indexes for the 10-year period that ended on Dec. 31, 2008. Cash is the asset equivalent of Rodney Dangerfield. It doesn't get much respect, which is too bad because cash is a wonderful portfolio component. How much to have is an individual judgment call, but a 10% minimum might be a good idea.

But if your portfolio was full of equities, like most investors', it didn't really matter what asset classes you had. Nearly all were gutted. Let's run through the one-year returns of the major equity asset classes (see "Equity Meltdown") to assess the damage.

The S&P 500 lost 37%, its worst one-year return since 1970. The Russell 2000's 33.8% drop was the worst since its inception in 1979. The 43.4% loss posted by the EAFE Index was the worst since 1970. The Dow Jones Wilshire REIT was down 39.2%, the worst one-year return since its inception in 1978, and the 46.5% drop of the S&P Goldman Sachs Commodity Index was the worst since its inception in 1970.

You get the drift. After examining the returns of the major equity asset classes, you can see that there were precious few places to hide in 2008. This wasn't a bear market, it was wholesale slaughter.

And yet, for much of the year, it was only moderately depressing. The real damage occurred during the fourth quarter. That is hardly comforting, because it illustrates how fast things can go from moderately bad to horrible.

In this article, we do our annual comparison of equity and equity fund performance. Was one less bad than the other in 2009? The answer to this question, as in years past, depends on the performance of one particular asset class: large-cap stocks.

Which Was Worse?

Let's specifically analyze the meltdown on this side of the pond. The rest of this article will focus strictly on the performance of U.S. stocks and U.S. stock mutual funds.

In 2008, there were 8,020 U.S.-based companies with 12-month returns as of Dec. 31, 2008. The average return of all 8,020 stocks in 2008 was -39.6%. The median return was -52.7%, whereas the market-cap weighted 12-month return was -26.6%.

Large-cap stocks fared better—or less badly. There were 218 large-cap stocks in 2008, which lost 29.5% on average. An additional 640 mid-cap stocks lost an average of 31.3%. And 5,338 small-cap stocks were down 47.2% on average. (A total of 1,824 stocks were not assigned a capitalization category.)

Of all 8,020 stocks, 89% had a negative return. The median negative return was -58.4%. Only 11% of all U.S. stocks had a positive return in 2008, and the median positive return was 19.9%.

Perhaps U.S. stock mutual funds did better than individual U.S. stocks? It all depends on how you look at it.

There were 2,781 U.S. stock funds that had at least a 12-month return as of Dec. 31, 2008. These 2,781 funds could not have more than 15% of their portfolio in cash, bonds or non-U.S. stocks. These filters were designed to isolate U.S. equity funds, but they also screened out inverse funds (funds that short equities and hold large offsetting positions in cash). This group of 2,781 domestic stock funds included large-cap, mid-cap, small-cap, value, blend, growth, actively managed and passively managed index funds.

The median return in 2008 for all 2,781 stock funds was -38.1%, which was "less bad" than the median return of -52.7% for stocks. However, 99.8% of all equity funds in this analysis had a negative return in 2008 compared with 89% of all 8,020 stocks that had a negative one-year return.

Among stocks with a negative return, the median one-year return was -58.4%. Among equity mutual funds with a negative return (all but five of them), the median negative return was -38.1%. Recall that the filters used to select the mutual funds in this study eliminated exotic inverse funds, many of which had positive returns in 2008.

The Large-Cap Factor

Simply put, almost all U.S. equity funds (specifically 99.8%) had large negative returns in 2008, while 11% of all U.S. stocks (881 to be exact) found a way to produce a positive return in the midst of an equity ice age. It may seem odd that a higher percentage of mutual funds had a negative return in 2008 than individual stocks. Actually, it's quite logical.

Nearly half of the 2,781 stock funds in this analysis are categorized as large-cap funds. However, only 218 of the 8,020 stocks in this study are classified as large-cap stocks. Therefore, nearly half of the stock funds are shopping from a short list of 218 large-cap companies, most of which performed very badly.

In fact, of those 218 large-cap stocks (i.e., the ingredients in a large-cap mutual fund), only 16 had a positive return in 2008. Bottom line: When most large-cap stocks do poorly, nearly all large-cap funds will do poorly. And because a large percentage of all mutual funds are large-cap funds, when the largest and most popular stocks perform badly, mutual funds in general get creamed.

To show how this works, we link the information on the percentage of U.S. stock funds and U.S. stocks with a negative annual return to annual index performance data (see "Looming Large"). Here's a look at the connection for each year from 1999 to 2008.

• 1999: The average one-year return of all 6,242 U.S. stocks was 42.7%, but the median return was -3.9%. Moreover, over half of all the stocks had a negative one-year return, but only 13.6% of all U.S. stock funds had a negative return. The most widely held stocks had fantastic returns in 1999. Microsoft was up 68.4%; Wal-Mart, 70.4%; Cisco, 130.8%; Citigroup, 70.1%; Home Depot, 70%; America Online, 95.2%; Sun Microsystems, 261.7%; Oracle, 289.8%; Qualcomm, 2,619%; and Sprint, 343%. Despite broad market weakness in 1999, most big stocks did well, and thus most mutual funds did well. The stellar performance of the biggest names also propped up the performance of all the major equity indexes.
  
  
• 2000: About the same percentage of stocks had a negative return, but now the losers included the big names. Microsoft dropped 62.9%, Wal-Mart was down 22.8%, Cisco lost 28.6%, Home Depot fell 33.3%, America Online plunged 54.1%, Sun Microsystems plummeted 28% and the list goes on. In 2000, the performance of the major equity indexes turned negative, since the big names were getting nailed. Thus, over half of all stock mutual funds had a negative return in 2000.
  
  
• 2001 and 2002: Conditions worsened for stock mutual funds despite the fact that about the same percentage of stocks had negative returns. It all depends on which stocks are having a rough ride. Interestingly, in 2001, the Russell 2000 was up 2.5%, but over 77% of all stock mutual funds had a negative return. Mutual fund performance is more affected by the performance of a relatively small number of widely held large-cap stocks than by the performance of thousands of thinly held small stocks.
  
  
• 2003: The equity market was kind to nearly all stocks. Only 15% of 5,758 stocks had a negative one-year return. As a result, 99.7% of all mutual funds were in the black. In fact, the median return of all U.S. stock funds in 2003 was a stunning 31.1%.
  
  
• 2004 to 2006: Widely held large-cap stocks did fine in 2004, had mixed results in 2005 and did very well in 2006. Thus, even though one-third to one-half of all stocks had negative returns in those three years, nearly all mutual funds were in the black.
  
  
• 2007: More stocks had a negative one-year return than in 2002. You couldn't tell this by watching the prominent large-cap indexes, however. The DJIA was up 8.9%, the S&P 100, 6.1% and so on. The index that revealed the underlying equity weakness was the Russell 2000. However, as most stock funds are more affected by large-cap stocks, nearly three- quarters of all stock funds had a positive return in 2007.
  
  
• 2008: Virtually all of the big-name stocks got nailed. The average return of the largest 100 stocks (measured by market cap) in 2008 was -25.2%. Only eight of the largest 100 stocks had a positive return. When widely held large-cap stocks take on water, a large percentage of mutual funds capsize.

In summary, mutual funds that invest in large-cap stocks are often dramatically affected by the performance of a relatively small number of large-cap stocks. Because of market-cap weighting, a portfolio of 500 or more stocks is not as diversified as you think.

Craig L. Israelsen's, Ph.D., is an associate professor at Brigham Young University. He is a principal at Target Date Analytics (www.TDBench.com) and the designer of the 7Twelve Portfolio (www.7TwelvePortfolio.com).