As you ring in the New Year, it's a great time to take a look at how your investments performed in 2010. But even though identifying winners and losers in your portfolio can teach you some valuable lessons, doing the wrong thing with that knowledge can cost you in the future.
Good news and bad news
If you have a diversified portfolio of investments, I have good news and bad news for you. The good news is that you probably have at least one or two investments that performed really well last year. But the bad news is that you'll also probably find some investments that you'd have been better off without.
Even investors who follow simple investment strategies go through this phenomenon each year. For instance, if you divide your stocks between U.S. and international ETFs, you might choose SPDR Trust (NYSE: SPY) and iShares MSCI EAFE ETF (NYSE: EFA) as your two core holdings. With the S&P 500 up nearly 15% when you include dividends, the S&P ETF handily beat the EAFE ETF's 6% return. You therefore might be beating yourself up for having wasted your time with developed-market international stocks last year.
Investors in individual stocks see even more extreme variation among the stocks they own. For example, casino stocks had a great 2010. Las Vegas Sands (NYSE: LVS) and Wynn Resorts (Nasdaq: WYNN) benefited from both the popularity of Macau as the prime gambling destination in Asia and improvement in their Vegas home markets. Similarly, Silver Wheaton (NYSE: SLW) rode the popularity of silver to big gains in its share price, as the company's silver-streaming business model effectively leveraged its exposure to increases in the price of the white metal.
But despite an overall positive year for the markets, there were plenty of lemons to be found. BP (NYSE: BP) looked like a completely reasonable stock to own at the beginning of the year, but shareholders got slammed by the Gulf oil spill. Similarly, Apollo Group (Nasdaq: APOL) and other for-profit educational companies suffered big share drops from government inquiries into their effectiveness and legitimacy.
The obvious kneejerk reaction
If you had a portfolio with some big winners and big losers, your first thought might be to jettison the losers and add to winners. Intuitively, that feels right to many investors; gainers give you positive feedback that you've made smart investment decisions, while losers undermine your confidence, suggesting that you've made a mistake and missed something important to your investing thesis.
But that first thought may be exactly the wrong one. Even though you should objectively evaluate your performance in order to decide whether you're making smart decisions in choosing investments, you can't apply your past results in evaluating whether you should continue to hold the stocks you own.
As much as you may want to be a buy-and-hold investor, one thing the lost decade taught investors is that price really does matter. What looks like a great company may be a bad investment when shares get too expensive, and even marginal companies can provide amazing returns if their stock gets cheap enough.
So when a stock has a really great year, it may follow it up with good future performance -- but it could also be more vulnerable to a setback. For instance, casino stocks have priced in a rosy future, but if the reality falls short of those lofty expectations, shares could stop rising even if the underlying businesses do reasonably well. Conversely, stocks that do badly could be just starting a downward spiral -- but they could also now be amazing values that will be great turnaround stories for 2011. BP, for example, still faces big uncertainties about its potential liability, but at its core, it's still a profitable business in a very promising industry.
Let diversification do its job
The whole point of having a diversified portfolio is to moderate your overall returns. When you choose to diversify your portfolio, you implicitly accept that you can't predict exactly which types of investments will perform the best. As a result, some of your holdings will go up while others go down.
But if you sell the losers and add to the gainers, you sabotage that diversification. If 2010's trends continue in 2011, then that move would amplify your returns -- but if they don't, then you could be taking on a lot more risk.
So as you judge your performance from 2010, celebrate your smart decisions and learn from your mistakes. But don't automatically dump losers in favor of winners. By keeping your commitment to a diversified portfolio, you'll protect yourself against the inevitable day when the next downturn will rear its ugly head.
Diversification is just one step in smart saving for your retirement. To learn more about getting your retirement saving back in shape, you'll want to get the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.
