You’ve heard the sage advice “Don’t put all your eggs in one basket.” That’s diversification. The S&P 500 is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. It is far more likely that one of those companies will go bankrupt in any given year than it is that 100 of them will. Each individual company has its own risks, and most companies can be accurately categorized into one of several different economic sectors, e.g., technology, banking, or mining, each of which is associated with different risks or cyclical trends.

By investing in only a few companies, you remain largely exposed to the “unsystematic” risks (that affect only an industry or a specific company) that each one faces. Conversely, by investing in a pool of different stocks, you lower the risk of a few bad apples wiping you out completely. You will also realize the additional benefit of reducing the overall volatility of your portfolio considering that losses in a diversified portfolio are often offset by gains, and vice versa.

This brings us to the third investment rule: Diversify Broadly.

What you’re betting on is that the combined change in value of all of your shares taken together will, over time, make you money. Historically, that’s been a safe bet. But over a long period, there will certainly be times when you’re down across the board. Understandably, those are tough times, but I will repeatedly tell you that the wisest course of action during those times is to wait and ride out the storm.

Diversifying is investing 101, but it’s easier said than done. Most individual investors lack sufficient resources to effectively diversify on their own. If you wanted to buy shares of 500 different publicly traded companies, you’d need over $2 million, and would incur prohibitive transaction costs. And your basket still wouldn’t include Small Value Stocks, International Stocks, or Bonds.

So Wall Street devised “commingled investment vehicles” that enable multiple investors to pool their assets to spread out their individual risk. Mutual funds, variable annuity subaccounts, and exchange-traded funds (ETFs) are examples of such vehicles. These vehicles achieve greater diversification, allowing individual investors to invest simultaneously in thousands of different stocks, with each investor owning a proportional share of those assets. By pooling assets with other investors, we achieve a far higher degree of diversification than we can alone.

Another important factor to consider in the context of your investments is the role of inflation.

In June 1975, when Steve Jobs and Steve Wozniak invented the Apple computer, actual apples cost around $0.34/lb. In September 2015, apples cost approximately $1.30/lb. – a 382% increase. That’s a fairly typical example of inflation, which, over the past forty years, has cumulatively totaled 343%. This means that if you had kept money under your mattress from 1975-2015, you would have experienced a loss of buying power of 343%.

Since the 2008 financial meltdown, Americans have benefited from a relatively low rate of inflation: approximately 1.5% per year. However, considering the vast quantity of money printed (known as “Quantitative Easing”) by the federal government since 2008, it is inevitable that inflation will make a resounding, and most unwelcome, return. Historically, assuming a 3% annual rate of inflation has been a good rule of thumb. Your investment advisor should strive to provide returns that exceed the benchmark index as well as the rate of inflation. That’s why stuffing money under your mattress is a poor financial strategy. Even if you don’t touch it, you’re losing approximately 3% in spending power every year.

Back when savings-account-interest rates were above 3%, banks could, at least, protect your nest egg from inflation. But since 2008, the federal Reserve has kept interest rates artificially low; the average savings account now pays interest at an annual rate south of 0.2% — only nominally higher than your mattress. That’s why even the most risk-averse investor has to be well-informed about financial planning, in general, and retirement planning, in particular.

Opportunity Cost is a calculation of gain forgone when funds are used for alternate purposes. For example, the “opportunity cost” of attending business school is not only the expense of tuition, but also the salary not earned during that two-year period.

Later, when we talk about conducting a “Portfolio MRI” to evaluate how well your own investments meet the 5 key rules to successful investing, we will talk about comparing the performance of your investments to appropriate benchmarks to see if you’ve made as much money as you could have made. One simple reason that people are not seeing the returns they ought to see is that they are invested in “retail funds” rather than comparable institutional funds. If you are in a retail fund, it is likely you are missing out on some of the gains that can be realized with institutional funds, which would reduce your costs. That alone would increase your expected return without changing your risk.

When the market value of investments declines, it’s natural to fear of falling short of your goals. Understanding Loss, Relative Loss, and Relative Gains can help alleviate such fears.

● Loss: Performance Loss occurs when a portfolio’s value decreases due to changing market conditions or a fall in a company’s earnings.
There are, however, more nuanced ways of understanding Losses.

● Relative Loss: Any fund’s performance can be compared relative to a benchmark index. This is a measure of opportunity cost relative to an index like the S&P 500. When an investor experiences a Relative Loss, their investment may increase in value, but rise less than it would have increased had you invested in the benchmark, itself.

For example, imagine that you invested in a mutual fund whose price increases 3% by year end. Even though the fund’s value has increased, you might still experience a Relative Loss if the S&P increased by 10% during that same time period.

Relative Gain. On the other hand, you can lose money in a fund but still have a Relative Gain if your own investments lose less than the benchmark index. If your funds lost 2% of their value but the S&P lost 5% of its value, you would have had a Relative Gain even if your investment declined in value since you lost less than the benchmark.

If you want a mechanic to be able to fix what’s wrong with your car, you must let him know about any peculiar sounds you hear (even if it requires admitting you shifted into reverse from third gear). Going to see your doctor requires similar honesty about things you don’t always want to reveal, such as actual diet and exercise habits, but this is necessary to obtain the best guidance and care. Similarly, to get the best advice from your financial advisor, be sure to let him know your important upcoming plans (such as retirement, or home purchase) as well as concerns (such as health, and health care costs).

You must feel comfortable enough with the person you delegate to invest and protect your money to be forthright, and not expect him to guess, or read your mind. That’s why you should apply as much care to choosing a financial advisor as to choosing a medical professional.

The first step in choosing a financial advisor is research. According to the Financial Industry Regulatory Authority (FINRA), only 15% of people do a simple background check on a potential financial advisor. Fortunately, there is a simple way to do this. The BrokerCheck website (BrokerCheck.FINRA.org) provides information about the advisor’s employment, registrations, and licenses, as well as any investment-related investigations, disciplinary actions, arbitrations, criminal records, or bankruptcies.

Before you meet with an investment advisor, recognize that every investor has a different risk profile. Your investment advisor, in consultation with you, should choose one that fits your unique needs and circumstances.

No discussion of investments can take place without an understanding of the fundamental concept of Risk. Investments that are high risk can provide a high reward . . . or may end up losing much of their value. An aggressive, risk-loving investor who doesn’t need the money in the near term may invest in riskier, more volatile assets. This approach is appropriate for someone with high earning potential who doesn’t expect to need the cash soon, for example, to purchase a house.

Risk Tolerance is your individual willingness to lose some or all of your investment capital in exchange for larger potential returns. An investor closer to retirement age probably has a lower tolerance for risk than the high wage-earner, and will likely favor a conservative investment approach to preserve capital. For this investor, a lower-risk portfolio that produces more modest returns is appropriate as it doesn’t expose the investment to the risk of losing value just when he is ready to retire.

Each investment strategy, however, also needs to be weighed relative to the tax implications of the investment. A high wage-earner may be in a high tax bracket, which means that his capital gains will be more heavily taxed than those of someone in a lower tax bracket. Make sure your investment advisor is knowledgeable both about a range of investment strategies and their tax consequences to help you keep as much as possible of what you gain.

The Myth: We can accumulate enough for retirement by saving cash and buying cash equivalents.

The Truth: Inflation robs cash, CDs and T-Bills of their purchasing power.

In 2014, a savings account typically paid 0.1% in interest. CD’s paid 0.7%. Inflation (see Financial Concept: Inflation) was a “modest” 1.7%. The money in a typical savings account or CD actually lost between 1.0% and 1.6% in purchasing power.

Let’s say you sock away $100,000 in cash for retirement, and inflation returns to 3% — the historical annual rate of inflation. That $100,000 effectively dwindles to $75,409.39 of purchasing power in ten years, $55,367.58 in 20 years, $41,198.68 in 30 years, and $30,655.68 in 40 years. Most people hope to spend 20, 25, 30 years or even longer in retirement. By “playing it safe” and putting your savings into CDs or T-Bills, etc., you’re allowing inflation to devour your retirement plans.

The Myth: High costs are offset by superior performance.

The Truth: A lot of buying and selling happens in the mutual fund investment process, incurring hidden costs that reduce your gains.

Theoretically, a fund could provide such superior returns that you’d benefit even if it charged more in fees. Lots of funds (and firms) would like you to believe that their performance justifies their fees. They rarely do, though it’s not always easy to tell exactly how much you are losing to fees or other trading costs.

Funds incur costs beyond just the management fees they charge. Even funds with low management fees incur hidden costs that appear only in the fine print. Whenever a fund manager buys or sells a stock, the fund pays for that transaction.

The Myth: Working with funds or financial managers that did well in the past is a good method of indicating which funds or managers will do well in the future.

The Truth: Past performance is no guarantee of future success.

One of the first things most people do before investing is look at a fund’s (or firm’s) record of accomplishment, aiming to find ones with a record of returns that beat a financial benchmark. In fact, the funds and firms depend on people doing so. Unfortunately, the disclaimer you’ve heard is true: “Past performance does not guarantee future results.” There’s no evidence of a long-term correlation. None.

According to the law of probability, a fund has a 50% chance of increasing in any year and a 50% chance of decreasing over the same time period. The fact that it increases one year does not change the fact that the following year it still has a 50:50 chance of increasing or decreasing.

In addition, the information provided about a fund’s returns are not the whole story. Brokerages may have hundreds or thousands of mutual funds that contain different mixes of the asset classes. By random chance, some will do well while others will not. What these funds advertise, but don’t explain, is that one of their funds achieved the “past performance” results that they promote. They don’t mention that all its other funds fell short of that level of performance. When you’re looking at past performance, remember that you’re only seeing part of the picture.

This is like misinterpreting the sign posted in casinos that reads something like, “We Pay Back 92% of Your Money!” (The exclamation mark is intended to make you believe that this is a good thing.) And 92% out of 100 is good – until you realize that it means that, on average, the best a gambler can hope to do is lose only 8% of his money. (Some people will win more than this average and some people will lose more.) Expecting a fund to achieve the same performance as it did the previous year is just gambling with your investment.

Mutual funds, retail brokers and financial advisors aggressively market funds awarded four and five stars by Morningstar, the Chicago-based arbiter of investment performance. But the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners. The search for top-performing stock funds is an exercise that will come to be viewed as one of the great financial follies of the late 20th century.

As the chart below illustrates, the reality is that even the top funds rarely exhibit the same performance for even two consecutive years.

From 2002–2012, on average only 7% of the top 100 fund managers repeated their performance the following year. In the years 2008 and 2009, no fund managers repeated their previous year’s top 100 performance.

Funds focus on “past performance” for one simple reason: because it works in attracting new investment. A Wall Street Journal and Morningstar study found that 72% of consumers invested their money in four- and five-star-rated mutual funds that showed the highest returns during the previous three–five years.

The Efficient Market Hypothesis states that it is impossible for anyone (without inside information) to predict outcomes in the market, because share prices always reflect all known information. Although analysts who follow different industries and companies are paid to have the most up-to-date information and insight into the unique circumstances affecting the companies they follow, it is unlikely for anyone to be able to invest in a significantly undervalued stock or be able to sell a significantly overvalued stock. People who make these predictions are making educated guesses that may pay off, but they are still guesses.

Beware of anyone who contends that he knows what the market or any investment will do over a given period of time.