Booming stock markets remind me of the best New Year's parties. The music's loud, the champagne is flowing, and everyone's having a fabulous time. But eventually, the party ends. And if you're not careful, it might be your portfolio that gives you a big hangover.
The year 2007 was a tough one for investors. Stocks finished up the year modestly, with the S&P 500's total return about 3.5%. But along the way, precipitous drops on several occasions left us queasy -- drops like these have been conspicuously absent in many of the last few years. If you were unprepared for market volatility, you may have made costly mistakes.
With conditions looking turbulent for the foreseeable future, now's a good time to resolve to get smarter about your investments. Here are a few ways to start.
1. Don't bet on one market.
Last year provided a great example of how diversification can improve your returns. Most investors put the vast bulk of their portfolios into large-cap U.S. stocks like those in the S&P 500, but many other types of stocks did better.
International stocks, for instance, fared better, with the portfolio value of the iShares MSCI EAFE Index ETF (NYSE: EFA ) up 8.5%, with holdings in telecom companies such as Vodafone (NYSE: VOD ) and Nokia (NYSE: NOK ) helping to pull up the overall index.
In addition, not all the gains were big-company stocks. The S&P 400 index of mid-cap stocks was up almost 7%, and several components, including GameStop (NYSE: GME ) -- which was promoted to the S&P 500 in December -- and Intuitive Surgical (Nasdaq: ISRG ) , had triple-digit returns. Even some types of bonds outperformed stocks. If you had all your investing eggs in the U.S. large-cap basket, you didn't do as well as you could have.
2. Know your risk tolerance.
It's easy to take risks when stocks are going up. But the markets reminded investors during 2007 that risks can dissolve those gains in a hurry. February's China surprise set the stage with a big one-day drop, and then the subprime meltdown gave stocks two 7.5% corrections within four months. Many panicked in response -- a reaction that was costly, as stocks rebounded quickly after each drop.
If you were uncomfortable during those drops, the smart time to do something about it is now, before the next crash comes. If you haven't looked at your investments over the past several years, the bull market may have you more heavily invested in stocks than you realize. There's nothing wrong with moving to a more conservative mix of investments -- especially if it prevents you from making bad decisions in unsettled markets.
3. Have an exit strategy.
Some investments are exactly right to buy and hold forever. Diversified mutual funds give you a portfolio that will change over time, as managers make new assessments about companies' prospects. Index funds simply give you the entire market rather than trying to separate winners from losers. With just a little attention, both types of funds keep your trading to a minimum.
With individual stocks, though, you need to have a plan in case things go wrong. For instance, homebuilder Toll Brothers (NYSE: TOL ) gave shareholders a loopy ride, jumping more than fivefold from 2003 to 2005. But if you had stuck with it and held your shares throughout the housing downturn, you'd have lost most of those gains over the past two years.
Of course, if a company is still a good long-term investment, you shouldn't dump it during a momentary slump. Learning when to sell will help you tell the difference between strong companies facing setbacks and businesses with bigger problems waiting to happen.
So as 2008 begins, resolve to get smart about your investments. No matter how the markets do in the coming year, following these steps will help you feel confident about your choices.
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