With the new year upon us, we can all breathe a small sigh of relief that a calamitous 2020 has finally passed. For all the hardship, pain, stress, and turmoil in the last year, the stock market gave some investors who stuck with it through the first-quarter swoon a silver lining. If you are reflecting on your investments from last year and setting goals for 2021, now might be a great time to review successful strategies and embrace some cornerstone habits of successful investors.
These New Year's resolutions should help you build on strong returns (or potentially reverse some disappointing performance) from the past 12 months.
1. Rebalance and reallocate
Consider a hypothetical portfolio that was evenly distributed among tech, industrial, consumer discretionary, healthcare, and emerging-markets stocks at the start of 2020. The tech sector outperformed the other categories substantially over the year, and it would likely have grown from 20% to 25% of the total allocation. If your investment goals and risk tolerance in 2021 haven't changed from the prior year, it's time to rebalance.
Rebalancing is a very important part of a sound long-term investing strategy, and for many investors, it's far easier said than done. Some stocks have delivered excellent returns, and it's wise to realize some of those gains by selling a portion of those stocks, taking that cash, and investing in other companies that also have strong performance ahead of them.
There's some science to determining how much of a portfolio should be invested in one stock or another, and that's largely based on investment goals and risk tolerance. That science can't be thrown out the window simply because Tesla (TSLA -4.23%), Etsy (ETSY -0.70%), and Zoom (ZM 0.79%) made shareholders a ton of money last year.
Rebalancing doesn't mean that you should dump your entire holdings of top stocks from years prior, but it's smart to lock in at least a small portion of those gains and search for better stocks for the future. Stocks that rise quickly become expensive, often limiting their future gains and increasing the risk of losses. Many of them cannot sustain those lofty valuations, and they fall especially hard during market corrections.
2. Take emotion out of investing
This is one of the smartest approaches to the stock market in general, and now is a great time to reaffirm your commitment to this goal. Good instincts might serve some investors pretty well, but long-term stock allocation should be governed by established principles rather than your gut.
Investors should measure their risk tolerance, review their investment goals, and come up with a group of stocks, bonds, ETFs, and mutual funds that fit with the goals and risk tolerance. If you can't handle (or afford) a large dip, then you should be careful about how much of your portfolio is invested in stocks rather than bonds. Risk-sensitive investors should be especially careful about owning too many highly volatile stocks, such as unprofitable growth companies or certain small caps. If you don't mind risk and want to maximize long-term growth, then you should be eager to take on more high-risk, high-reward stocks with long-term promise; temporary setbacks in the market aren't going to blow up your financial plan.
Research by academics and firms such as Dalbar often shows that the average investor's performance significantly lags the stock market overall. Unfortunately, this is usually caused by people sabotaging themselves by reacting emotionally to news. Some fearful investors who panicked about COVID-19 or the presidential election results completely missed out on some of the all-time highs in 2020. Conversely, plenty of optimistic investors were decimated by internet stocks in 2001 after the Dot-Com Bubble burts and financial stocks in 2008 during the Great Financial Crisis. A robotic approach would have avoided most of these issues, while emotional decision making would have doomed investors to potentially catastrophic failure.
Come up with a well-reasoned long-term strategy, and stick with it. Make small adjustments over time as the world changes or your risk tolerance evolves, but avoid wholesale major changes based on emotion.
3. Embrace ETFs
There's absolutely nothing wrong with owning individual stocks. However, investors should be very careful to avoid attaching their financial plans too closely to the performance of a handful of companies. If you only own five stocks, and one of them turns out to be the next Blockbuster, things can get ugly. Diversification through owning many stocks is a smart way to dilute that risk, and that's why it's a core component of most investing strategies.
ETFs are fantastic financial vehicles for most investors. They provide cheap and easy diversification, they are often very liquid on a secondary market just like stocks, and they are usually slightly more tax efficient than comparable mutual funds. Investors can opt for a fund that tracks the entire market, such as the SPDR S&P 500 (SPY -0.23%), an ETF that tracks a broad sector, such as the Technology SPDR (XLK 0.21%), a geographically specific fund like the Vanguard Pacific ETF (VPL 0.59%), or something more niche like the iShares Dow Jones Medical Devices ETF (IHI -0.31%). An ETF strategy can be active or passive, with all different levels of specificity, so most investors would benefit from leaning on these tools for improved allocation and results.