Alas, the frothy days of 2021 are all but a distant memory as the market has come crashing back down to reality this year. The Nasdaq Composite is down more than 28% in 2022, and many growth and tech stocks have seen worse losses.
The reality is that many of these stocks, after reaching stratospheric valuations last year, may never see those valuations again -- or at least not for many, many years. If you go back to the dot-com crash near the turn of the century, you'll see that many stocks from that period have never attained those levels again, despite performing solidly since then.
While it can be a bit depressing to dwell on the past, you shouldn't worry too much. There are ways to not only learn from what happened in the past year but to also turn the situation to your advantage.
Think about what went wrong
I think it's safe to say retail investors got a little carried away in 2021. Don't beat yourself up too much, because we've all been there. But this doesn't mean you can't take this as an opportunity to learn.
As many of you likely know, there was a ton of excess liquidity running through the markets in 2021. Consider how high personal savings were, the stimulus checks and programs, and the Federal Reserve's aggressive pumping of money into the economy through quantitative easing.
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This inflated a lot of assets, including real estate and stocks. Expectations regarding inflation and interest rates were also pushed out much further than what ended up happening, so people weren't as concerned about what would happen this year. Suddenly, stocks were hitting meteoric valuations, and instead of trading on earnings multiples, they were trading on sales multiples -- and wild ones, like 30 or 60 times sales.
The lesson we can all learn here is to not let investor sentiment -- no matter how bullish it may seem -- lead you astray from your investing fundamentals. It's not as easy as it looks, but one thing we can all do is focus a little more on the valuation. Here are some questions you might want to ask yourself when investing in a stock:
- Is the valuation too high?
- Does it accurately reflect the expected growth and projected earnings?
- Can you do some basic math or make some reasonable assumptions to justify the earnings and valuation?
If the answer is yes, then you've probably made a reasonable long-term bet. But if the math isn't adding up, then you need to slow down and revisit the investment thesis and assumptions baked into the valuation. It's also never a bad idea to shave a few points off that multiple or earnings projection and stay conservative. In the end, you'll probably be happy you did, because then any downside is less problematic and any upside is more of a nice surprise.
Dollar-cost averaging
Given what I discussed above, now go back to your portfolio and look at any stocks you might have bought when they were soaring in 2021 that are now struggling this year. Compare their valuations from then and now. If the valuation is much more reasonable now, or even at depressed levels, then this could be a great opportunity to buy the stock and bring down your average cost.
For instance, one popular growth stock that has been on a roller-coaster ride the past year is payments giant PayPal. The stock rose from about $120 prior to the pandemic all the way to its peak at $308 in the middle of 2021. Since then, it has come crashing down to about $86 per share. There were times in 2021 when the stock traded at more than 80 times earnings.
PayPal may have a great business that will benefit from the further adoption of digital payments long-term, but investors got ahead of themselves. So if you had bought shares for around $300 in 2021, you could buy a similar number for around $86 now and bring your average cost below $200 per share.
Going forward, you can apply this concept to investing through an even more proactive approach called dollar-cost averaging. This method involves regularly investing the same amount of money in a stock over time, like every few weeks or months. This will smooth out your average cost over time, so you don't have to worry as much about getting in at the perfect price.
Learn from your mistakes
The great thing about investing is it always provides an opportunity to learn from your mistakes, because everyone is making them (often many of them) along their journey. Most retail investors likely purchased a stock when it was trading way too high last year.
That's OK, because you may still be right long-term. And this year gives you an opportunity to purchase shares at a much more reasonable valuation that will get your average cost down.
Plus, now you know not to get too caught up the next time the market gets overly frothy. Focus on buying stocks with great business models at reasonable valuations.
