Platitudes rarely help, and yet, you can see them everywhere, even professional financial advisors say them. But what regular individual investors – especially beginners – need to know are real, practical principles for handling their investment portfolios. Fortunately, the most knowledgeable and successful people in the field have provided us with timeless advice that any investor can benefit from.

The content of this post does not constitute financial advice. It is intended for educational purposes only.

#1 KEEP YOUR EMOTIONS AND BIASES IN CHECK

One of the strongest driving forces of irrational investing behavior and overreaction in markets is emotions and biases. They are innately human, they exist within every person, but allowing them to take over and dictate investment decisions can be a significant and very costly mistake. One example is investing because of the fear of missing out (FOMO). We might hear from the news or social media that some stock or fund or other type of asset is currently trending a lot, that a lot of people are getting rich at the moment as money is being poured into it. We want to jump on the bandwagon and share in the profits. Without considering that (1) this particular investment might not be suitable for us and our risk tolerance, and (2) the price of that asset has already moved too high (or too low), to unsustainable, maybe unjustified levels based on the actual performance of the underlying company or its ability to repay its debts, etc. Another common example is panicking. Markets tend to experience short-term shocks, which affect a multitude of assets due to broad rapid shifts in sentiment (risk-on/risk-off). This can often affect stocks or assets that are otherwise sound and strong investments. But panicking and following the herd might feel like the correct thing to do when we see red (i.e., losses) on the screen and have no strategy in place on how to act in such situations.

Certain biases that you have developed over the years could also prove to be a persistent setback for achieving your financial goals. For instance, overconfidence is a very common one, where one thinks nobody else could know better, when you have collected so much information you believe sincerely in your investment thesis or ideas. It could make you blind to any pieces of evidence or data that contradict your ideas because you are completely convinced you cannot be wrong. Another example is confirmation bias, where you persistently ignore information that does not match your views and only favor information that supports them. But it is crucial to remember, that all relevant pieces of information matter in an investment decision, even the ones we don’t like – as they might reveal an aspect that undermines our strategy or points to risks that are not obvious but could cause significant losses in the future.

What should you do to avoid making these kinds of mistakes?

1. Define a suitable strategy and adhere to it. This reduces the reliance on momentary moves and emotional reactions and lowers the possibility of panic, fear, or unjustified excitement. Commitment is key to successful investing.

2. Be aware of your biases and gather experience in different market environments. Analyze your own actions and past mistakes. Understand what you did wrong and why, and how you could have done it better. Be prepared for fluctuations, including extreme ones – and define in advance how, depending on their different nature, you would act – i.e., have your own rulebook and follow it.

3. Stop yourself from blindly following the crowd/the herd. You have your own personal circumstances, portfolio, financial goals, and needs – that means, not all investments that are trendy will be suitable for you. If your advisor offers you some investment because it’s trendy or popular – they are doing you a disservice. Do your due diligence and analysis – collect and understand all relevant information. Make your choices based on what works for you and all available relevant information.

#2 DIVERSIFY

This is fundamental and is said quite a lot – and yet, a lot of people ignore it or forget about it – do not put all your eggs in one basket. That means diversifying not just across various stocks, but various asset classes, various sectors of the economy, even different countries and currencies, and different account types and providers. There are many aspects to diversification, and one always needs to consider the ones most applicable to one’s own situation. Yes, for some individual investors, infinite buffers of accessible cash could mean they can afford to concentrate their portfolios in one asset they truly believe in. But those are exceptional cases, most people don’t have that luxury. For the average investor, at least some level of diversification makes sense and could prevent major drops in portfolio value.

How to correctly apply diversification in practice? Break down and understand what risks you are exposed to. You can only benefit from diversification if you ensure the risk factors you are exposed to are different and not perfectly correlated with each other. Think about what drives the performance of companies in various industries, what macro factors influence various asset classes, whether different countries or sectors are tightly interconnected, etc. That does not mean just blindly adding things that are uncorrelated, but rather ensuring you add investments whose risk and return profile is still suitable for you as an investor, while they are still not perfectly correlated.

#3 MINIMIZE INVESTMENT AND TRADING COSTS

Trading costs and investment fees can become a very significant drag on the performance of your portfolio. They might seem small in relative terms, but their impact compounds over time and can subtract a significant portion of your profits, especially if you are a long-term investor. For example, if you invest $100,000 for a period of 20 years and earn an average annual return of 4%, then you would have:
– $219,112 final portfolio value, i.e. over $119k profit if there were no investment fees;
– $208,815 final portfolio value if the fees were 0.25% p.a., i.e. an over $10k lower profit than in the case without fees;
– $198,979 final value if the fee was 0.5% p.a., that is over $20k less in profit compared to the case without a fee;
– $180,611 final value if the fee was 1% p.a., i.e. over $38.5k difference from the case without fees. This impact on your profits becomes quite material, the higher this percentage goes. Which is why going for actively managed investment alternatives is usually not justified for individuals, as the costs there can make the final return negative. You can see this example visualized in the graph below. Always keep track of the applicable fees. And be aware of trading fees, too – they will affect your profits more, the more frequently you transact. This is one key reason financial planners and investment advisors often use as a justification why buying and holding could be a preferred strategy for most individual investors.

#4 The right asset allocation

Asset allocation is the mix of different assets and asset classes in one’s portfolio and according to research, it is the single most important driver of portfolio performance over time. Internet brokers, online banks, automated advisors, etc., often advertise some fixed, broadly defined allocation mixes to simplify and attract less knowledgeable clients (i.e., classic 60/40 portfolio meaning 60% stocks + 40% bonds, some conservative combination like 20%/70%, and aggressive ones like 90% stocks).
These simplifications, while sometimes useful for some situations and purposes, should not be taken as universal allocation rules. Ideally, the allocation should be customized based on your existing portfolios and investments, financial situation and circumstances, needs, goals, risk tolerance, return objectives, limitations, etc. To this end, getting help from a financial planner or investment advisor might be best. But if you are thinking of determining it on your own, then you need to consider several things:

1. Your age and investment horizon. This is a key factor in your tolerance to assume more risk in your portfolio and expose yourself to riskier asset classes such as stocks, alternative investments, or cryptocurrencies. Your age tells you how much ‘human capital’ you have left in terms of your potential for future earnings and your ability to recover from future losses or a loss of a job/income. And your horizon tells you if you will be able to last through some regularly occurring market fluctuations. The longer you are planning to hold certain assets, the more the likelihood that these assets have negative returns is reduced.

2. Your overall tolerance for risk and other financial and personal circumstances. Do you think you will need more cash flow in order to support dependents? Do you think a large purchase is upcoming and you will need a higher degree of liquidity in your portfolio? Are you comfortable with assets that fluctuate a lot, or assets that can go up 90% and go down 90% in a short period of time? Do you already have significant exposure to a given stock or sector in your portfolio – and are you planning to add more, thus increasing your concentration risk further?

3. What environment are you making this decision in? The economic and policy regime matters as it influences what might come next. For instance, investing too much in bonds when interest rates are at rock bottom and inflation is just starting to rise, puts you at a risk of significant losses once the central bank starts raising policy rates to counter inflation. In that environment, bond values go down.

4. Think strategically, including about megatrends. If you are investing over long horizons (10-20-30 years), do some research, inform yourself of long-term business cycles and trends, find out what has the potential to perform well over such horizons, what new technologies are coming up, what other changes in various sectors and industries might be developing. No one really knows for sure what will happen, but there is enough research and analysis out there to form an opinion and make an informed, fact-based decision. And you can use future investment dates to enhance your portfolios when changes take place or other new sectors or businesses come along that show more promise for profit growth.

#5 FOOLED by patterns and shapes

Looking for some obvious visual or statistical clues or repetitive patterns is something that our brains like and easily find ways to assign some logic to. But this propensity to look for those patterns or relationships could also mislead us into seeing something that is not really there. That is especially true for charts in technical analysis, where skilled analysts can basically produce whatever graphical analysis they see as fitting their story best, and then try to use it as justification for trades. It is also often the case with statistical relationships – for instance when investors mistake correlation for causation in an attempt to assign economic significance and meaning to some moves in markets.
Remember that sometimes the reasons for certain market moves are not a function that can be mathematically well defined, or based on changes in company fundamentals or macro variables, or even visible in chart patterns and technical indicators. And those might not always have predictive power over what comes next. This is especially true over short time horizons when volatility can be caused by rapid shifts in sentiment that are not easily predicted. But certain relationships might hold much better over longer horizons and for most individual investors, those are the ones worth monitoring and understanding.

#6 Pay attention to the credit cycle

Modern economies are built on credit. The credit cycle – i.e., the sequence of phases of easier and tighter access to credit – is therefore a main driving force of the developments in the economy. It is also extremely volatile and influenced by changes in monetary policy, which is why sometimes it can produce extreme impacts, affecting many forms of activity, and exacerbating the psychological swings mentioned in point 1.

Changes in credit availability impact households, corporations, and the functioning of all financial markets. That’s because financing is a key element of the productive process, growth, and consumption. Its necessity is also caused by the fact that ongoing activity often needs debt funding to be refinanced once it matures – the rollover of credit. If this is not possible, companies might default, causing growth to stumble and unemployment to rise. What is even more important – the financial system, the institutions that form the plumbing of our economies, have a special place in the credit cycle, as they provide financing and also need access to financing. They do that through maturity mismatches, which, in extreme swings in the credit cycle, can create major disturbances in the entire financial system and potentially cause meltdowns.

Howard Marks describes the credit cycle as follows:
1. The economy is in a period of prosperity – capital providers thrive and their capital base is increasing. Bad news is scarce, hence the risks in lending and investing appear to be very low. There is virtually no risk aversion. Financial institutions grow their business and provide more credit – they compete for market share by lowering rates and easing credit standards and covenants.
2. The worst loans are being made during the best of times – as competition is high and profit-seeking/risk-taking are prevalent, little attention is paid to the quality of borrowers and projects being financed, resulting in misallocations. Many of them are potentially unprofitable in the medium or the long run, leading to capital destruction.
3. When this happens, the cycle moves into reversal – losses increase gradually at first and then accumulate more rapidly, causing lenders to become more averse to further lending. Risk appetite reverses. Interest rates and credit availability and covenants become more restrictive – banks increase their requirements from borrowers. With the reduction of credit flowing through the system, come companies starve for capital and become unable to roll over their debts. This results in defaults and bankruptcies rising, thereby reinforcing the contraction of the economy.
4. Once the economy is purged of the previous excesses, the cycle reaches a trough and restarts again – surviving firms (generally strong, high-quality borrowers) and new businesses need capital for investment, in areas where potential returns are high. Competition to make loans or investments is still low and high potential returns attract capital flows, kicking off a recovery.

As the credit cycle turns in step 2, and capital flows out of certain investments and asset segments, identifying those with high quality is essential as their prices are likely to decline, but they will survive and very likely profit and appreciate again in a recovery and future growth. This is why recognizing the phases of the cycle and using that for investment decisions provides an enormous advantage.