Investing in last year's top 10 stocks is 'a recipe for disaster,' expert says

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Look back on the best-performing stocks in a given year and you’re likely to see a mixed bag: some mainstays, some breakouts and maybe even a meme stock or two.

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The ten highest-performing S&P 500 stocks in 2022 belonged to the energy sector.

Not so in 2022. Each of the 10 top-performing stocks in the S&P 500 index belonged to the same sector: energy.

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In a year in which every other sector in the S&P 500 lost money, energy stocks delivered an average return of 59%, with top performer Occidental Petroleum returning 119%.

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However, that doesn’t necessarily mean you should go out and add any of these stocks to your portfolio now, investing experts say.

Following an overall down year in the market, “don’t chase the few things that have performed well,” Christine Benz, director of personal finance and retirement planning at Morningstar, told CNBC Make It. “Doing a complete repositioning of your portfolio is a recipe for disaster.”

Here’s why investing experts say to tread carefully before adding last year’s winners to your portfolio.

You’re historically slightly better off buying losers

The market operates in cycles, and this has been a particularly good one for companies involved in the discovery, transportation and sale of oil and natural gas. Energy prices shot up early in 2022 after Russia invaded Ukraine and the U.S. and EU took steps to curtail Russian energy exports.

But a cyclical market means eventual reversion to the mean. Energy will come back to the pack, and laggards will catch up. There’s no telling when that will actually happen, but historically losers have outperformed winners following a down year.

“If it’s an up year, history says to let winners ride. However if the prior year was down, you’re better off rotating from ‘first’ sectors like energy to ‘worst’ sectors like technology and consumer discretionary,” said Sam Stovall, chief investment strategist at CFRA.

By Stovall’s calculations, a “first to worst” rotation has beaten the market 60% of the time since World War II.

That’s isn’t to suggest you shift your entire portfolio into tech, the worst performer in 2022. Rather, it illustrates that the factors that drive certain corners of the market to take off are unpredictable from year to year.

Choose stocks sparingly and carefully

If you’re a long-term investor, financial advisors generally recommend building a broadly diversified portfolio. By spreading your bets across a wide array of asset classes, you decrease the chances that a sharp drop in any one particular investment derails your portfolio’s performance.

For that reason, investors are typically told to steer clear of devoting too much space in their accounts to any one particular stock. Unlike the broad market, which has historically trended upward, any one stock has the potential to go to zero.

If you do want to invest in a few stocks as a complement to your core broad-based investing strategy, ignore which way the market is trending and examine each stock on its own merits, experts say.

“As long-term investors, we don’t try to chase momentum,” said Dave Sekera, chief U.S. market strategist at Morningstar. “We focus on opportunities where the market doesn’t understand the intrinsic value of a company.”

There are plenty of ways to determine a company’s value, and each investor has their favorites. You may want to focus on how a stock trades relative to the company’s earnings or cash flow, for instance.

No matter which measure you choose, the more a company’s stock price has run up, the more likely it is that it’s trading more expensively relative to peers, the broad market and its historical averages. And there tends to be some mean reversion there, too.

Headed into 2022, energy stocks were the most undervalued by Morningstar’s calculations. And after a 59% runup? “It’s the sector we now think is the most overvalued,” Sekera said.

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