It may surprise some to learn just how well some tried-and-true investing principles proved their worth in this wild year. If investors had merely turned off the news and followed some bedrock investing principles we preach here at the Fool, they probably would have done quite well in the incredibly abnormal 2020 market, and likely without too much anxiety.
Whether you did terrifically in the market in 2020 or missed out on the rally, don't worry. Keeping a cool head and these five investing lessons top-of-mind should pave the way for investing success in 2021 and beyond, especially for beginners.
Lesson No. 1: Expect the unexpected
After a big recovery year in 2019, during which the S&P 500 gained 28.5%, some might have expected some sort of correction in early 2020. I don't think many had penciled in a once-in-a-century global pandemic that would shut down a good portion of the economy.
As Mark Twain once said, "It is difficult to make predictions, particularly about the future."
The long-term return for the stock market is around 8%. In order to earn that long-term return above risk-free interest rates, you have to take on some risk. In just the past 20 years, we've seen the bursting of the tech bubble, the housing market crash leading to the Great Recession, the European sovereign debt crisis of 2011, the trade war/interest rate crash of late 2018, and the COVID-19 pandemic of 2020.
Consider these market meltdowns the price of admission to participate in the long-term wealth creation machine the stock market offers.
Lesson No. 2: Hold on for long-term market trends
Another thing no one predicted: That amid a global pandemic that shut down roughly a fifth of the economy and killed 1.7 million people worldwide, the S&P 500 would be up 16.9% (with dividends included) with a week left to go in the year.
The depths of the March decline -- the fastest in market history -- were scary. However, if you just stuck with your own investing plan to buy index funds or high-quality stocks at regular intervals, you likely did just fine. There's definitely something to be said for taking the thinking out of your investment process, especially regarding asset allocation and market timing.
Yet how did the market pick up so fast in 2020 specifically?
First, the market is a forward-looking discounting machine. Look to the next two lessons for the second and third reasons.
Lesson 3: Don't fight the Fed
The long-term returns of the stock market generally offer between a 4% and 6% premium over risk-free rates. The risk-free rate itself, as well as its expected trajectory, can thus profoundly affect stock market returns.
When the market gets overheated and inflation picks up, the Federal Reserve generally looks to raise interest rates to cool things down. However, that hasn't happened in earnest for quite a while. After the financial crisis of 2008-2009, the Federal Reserve kept interest rates at or near zero and bought Treasury securities for much of the next decade. When the Fed preemptively tried to raise shorter-term risk-free rates in 2017 and 2018, the market had a very adverse reaction.
Yet in March, the Fed took decisive action, lowering the federal funds rate to zero. It recently pledged to keep them there through 2023 until the economy picks up. In an unprecedented step this spring, it also bought a diverse set of corporate bonds and exchange-traded bond funds on top of its traditional treasury-buying program. That put a floor under the debt markets, allowing otherwise strong companies to raise money in the depths of the pandemic.
While the Federal Reserve doesn't control the longer end of the yield curve, short-term rates tend to inform longer-term expectations of inflation. With short-term rates at zero, expectations for inflation are low. Currently, the 10-year U.S. Treasury rate yields a paltry 0.95% and the 30-year Treasury rate is only 1.7%.
That means if you invest in a U.S. 30-year bond, you'll receive 1.7% annually (before taxes!) for 30 years, with no potential for growth. When you look at that alternative, earnings yields of many high-quality stocks -- even those trading for 30 or 40 times earnings, equal to earnings yields of 3.3% and 2.5%, respectively -- look pretty attractive by comparison.
Low interest rates tend to buoy the markets. They have been at least partially responsible for the outsized gains this year, and really over the past 12 years.
Lesson No. 4: Don't bet against innovation
Of course, the COVID-19 crisis only highlighted the incredible importance of technology and biotechnology in our economy today. Unsurprisingly, those two sectors have absolutely taken off this year, with returns above the overall market.
Thanks to the incredible strides in internet connectivity and cloud computing over the past decade, many large corporations were able to seamlessly transition to working from home in the early days of the pandemic. That allowed critically important industries to keep the lights on without missing a beat.
Thanks to massive strides in biotechnology, and specifically the innovation of mRNA vaccine technology, Pfizer (PFE -5.25%) and Moderna (MRNA 2.78%) were able to produce coronavirus vaccines within 10 months of the virus breakout. More vaccines are likely on the way as well. It's an incredible feat of human ingenuity that was many years in the making.
Unsurprisingly, these leading tech and biotech companies were among the first stocks to surge after the initial March drawdown. The successful vaccine announcement helped other more-affected industries such as travel, entertainment, and cyclical stocks surge during November, adding another leg to 2020's massive gains.
Lesson No. 5: Shorting stocks is a difficult business
Finally, another big lesson this year is that shorting stocks is really, really hard. Not only that, it's incredibly risky. If a stock you buy goes to zero, you can only lose 100%. However, if you short a stock, your losses are unlimited.
If there was ever a time to be short stocks, it would have been in March of this year. However, the time period in which you would've looked like a genius was pretty short. After the March crash, stocks went on to enjoy an unprecedented recovery -- in fact, the fastest ever from a big market correction.
2020 was also a year when many expensive-looking stocks that might've attracted shorts went on to double, triple, or even rocket 10 times higher. As people were shut down in quarantine, a wave of retail investors using new-age investing apps like Robinhood speculated on many fashionable stocks. These included the aforementioned tech and biotech names, along with electric vehicle stocks, beaten-down travel names, and later in the year, a surge of new IPOs.
Take Tesla (TSLA -0.81%), which had a fair amount of short interest to start the year as investors were skeptical over its growth story, balance sheet, and valuation. However, better-than-expected delivery results and speculation over Tesla joining the S&P 500 index, and perhaps some of that newfound Robinhood investor enthusiasm caused the stock to boom.
Yet while Tesla was the poster child for the hazards of short-selling, it was far from the only example. The lesson? Unless you're a professional short-seller, most investors should stick with going long, where time is on your side.
What will 2021 bring?
These five tried-and-true investing lessons held true in 2020, but will there be a sea change in 2021? Probably not. These lessons are universal and timeless. Trying to time the markets is always a fool's errand. If you spend less than you make, invest at regular intervals, and keep these lessons in mind in 2021 and beyond, you should have no problem compounding your wealth by that long-term 8% rate... and maybe even better.