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SECTION 2

THE UNSHAKEABLE PLAYBOOK

CHAPTER 6

THE CORE FOUR

The Key Principles That Can Help Guide Every Investment Decision You Make

Let’s make it simple. Really simple.

—STEVE JOBS, cofounder of Apple

Anyone can get lucky and win the lottery. Anyone can pick a winning stock from time to time. But if you want to achieve lasting financial success, you need more than just the occasional lucky break. What I’ve found over almost four decades of studying success is that the most successful people in any field aren’t just lucky. They have a different set of beliefs. They have a different strategy. They do things differently than everyone else.

I see this in every area of life, whether it’s sustaining a happy and passionate marriage for more than a half century, losing weight and keeping it off for decades, or building a business worth billions.

The key is to recognize these consistently successful patterns and to model them, using them to guide the decisions you make in your own life. These patterns provide the playbook for your success.

When I embarked on my journey to find solutions that could help people financially, I studied the best of the best, ultimately interviewing more than 50 investment titans. I was determined to crack the code—to figure out what explains their stunning results. Above all, I kept asking myself one question: What patterns do they have in common?

As I soon realized, it was a remarkably difficult question to answer. The trouble is, all these brilliant investors have entirely different styles and approaches to making money. For example, Paul Tudor Jones is a trader who makes huge bets based on his macroeconomic view of the world. Warren Buffett makes long-term investments in public and private companies that possess a durable competitive advantage. Carl Icahn targets businesses that are underperforming, and then cajoles (or bludgeons) management to change its strategy in ways that can benefit shareholders. Clearly, there are many different paths to victory. Finding common denominators was quite a challenge!

But over the last seven years, I’ve done what I’ve always loved doing, which is to take complex subjects that seem overwhelming and break them down into a few core principles that people like you and me can actually utilize. So what did I discover? I came to realize that there are four major principles that nearly all great investors use to guide them in making investment decisions. I call these the Core Four. These four patterns, which I’ll explain in this chapter, can powerfully influence your ability to achieve financial freedom.

Do you remember what I said earlier about complexity being the enemy of execution? Well, when I tell you about these four principles, you might respond by saying “How basic! How simple!” And you know what? You’re right!

But it’s not enough to know a principle. You have to practice it. Execution is everything. I don’t want to needlessly complicate matters so that you end up sitting on a mountain of rich information but don’t know what to do with it. My goal isn’t to dazzle you with elaborate arguments. It’s to synthesize, simplify, and clarify so you feel empowered to take action now!

Together these principles provide us with an invaluable checklist. Whenever I’m speaking with my financial advisors about a potential investment, I want to know whether or not it meets the majority of these four criteria. If not, then I’m simply not interested.

Why am I so adamant about this? Because it’s not enough to say “These are useful insights; I’ll try to keep them in mind.” The best investors understand that these principles must be obsessions. They’re so important that you need to internalize them, live by them, and make them the foundation of everything you do as an investor. In short, the Core Four should be at the very heart of your investment playbook.

CORE PRINCIPLE 1: DON’T LOSE

The first question that every great investor asks constantly is this: “How can I avoid losing money?” This may sound counterintuitive. After all, most of us focus on exactly the opposite question: “How can I make money? How do I get the biggest possible return and hit the jackpot?”

But the best investors are obsessed with avoiding losses. Why? Because they understand a simple but profound fact: the more money you lose, the harder it is to get back to where you started.

I don’t want you to feel like you’re back in your high school math class! But it’s worth pausing to clarify why losing money is such a disaster. Let’s say you lose 50% of your money on a bad investment. How much will you need to earn to make yourself whole again? Most people would say 50%. But they’d be dead wrong.

Let’s look at it. If you invested $100,000 and you lost 50%, you now have $50,000. If you then make a 50% return on that $50,000, you now have a total of $75,000. You’re still down $25,000.

In reality, you’ll need a 100% gain just to recoup your losses and get back to your original $100,000. And that could easily take you an entire decade. This explains Warren Buffett’s famous line about his first two rules of investing: “Rule number one: never lose money. Rule number two: never forget rule number one.” Other legendary investors are equally obsessed with avoiding losses. For example, my great friend Paul Tudor Jones told me, “The most important thing for me is that defense is 10 times more important than offense. . . . You have to be very focused on protecting the downside at all times.”

But in practical terms, how can you actually avoid losing money? For a start, it’s important to recognize that financial markets are wildly unpredictable. The talking heads on TV can pretend as much as they want that they know what’s coming next. But don’t fall for it! The most successful investors recognize that none of us can consistently predict what the future holds. With that in mind, they always guard against the risk of unexpected events—and the risk that they themselves can be wrong, regardless of how smart they are.

Take Ray Dalio. Forbes says he’s produced $45 billion in profits for his investors—more than any other hedge fund manager in history. His net worth is estimated at $15.9 billion! I’ve met a lot of extraordinary people over the years, but I’ve never met anyone smarter than Ray. Even so, he told me that his entire investment approach is built on his awareness that the market will sometimes outsmart him, veering in a totally unexpected direction. He learned this lesson early in his career, thanks to what he described as “one of the most painful experiences” of his life.

In 1971, back when Ray was a young investor learning his trade, President Richard Nixon took the United States off the gold standard. In other words, dollars could no longer be directly converted into gold, which meant that the US currency was suddenly worth no more than the paper on which it was printed. Ray and everyone he knew in the investment community were certain that the stock market would plummet in response to this historic event. So what happened? Stocks skyrocketed! That’s right. They did the exact opposite of what logic and reason told him and all the other experts to expect. “What I realized is nobody knows and nobody ever will,” he says. “So I have to design an asset allocation that, even if I’m wrong, I’ll still be okay.” That, my friend, is an insight that you and I should never forget: we have to design an asset allocation that ensures we’ll “still be okay,” even when we’re wrong.

Asset allocation is simply a matter of establishing the right mix of different types of investments, diversifying among them in such a way that you reduce your risks and maximize your rewards.

I don’t look to jump over seven-foot bars: I look around for one-foot bars that I can step over.

—WARREN BUFFETT

We’ll discuss the ins and outs of asset allocation in much greater depth in the next chapter. But for now, it’s important to remember this: we should always expect the unexpected. Does that mean we should hide away in fear because everything is so uncertain? Not at all. It simply means that we should invest in ways that help to protect us from nasty surprises.

As you and I both know, many investors get hurt by market bubbles because they start to act as if the future will bring nothing but sunshine. As a result, they throw caution to the wind. Long-time winners such as Bogle, Buffett, and Dalio know the future will be full of surprises, both pleasant and unpleasant. So they never forget about their downside risk, and they protect themselves by investing in different types of assets, some of which will rise while others fall.

I’m no economist or market seer! But it strikes me that this emphasis on avoiding loss is particularly relevant today, given that none of us can predict the effect of the radical economic policies we’re seeing around the world. We’re in uncharted territory. As Howard Marks told me in late 2016, “When you’re in an uncertain world with high asset prices and low prospective returns, I think that should give you pause.” At his $100 billion investment firm, Oaktree Capital Management, the mantra in recent years has been “Proceed with caution.” He explains: “We are investing. We’re fully invested. We’re happy to be invested, but everything we’re buying has an unusually high degree of caution.” How do I apply the “Do Not Lose” principle in my own life? I’m so obsessed with this idea of not losing that I now tell all my advisors, “Don’t even bring me an investment idea unless you first tell me how we can protect against or minimize the downside.”

CORE PRINCIPLE 2: ASYMMETRIC RISK/REWARD

According to conventional wisdom, you need to take big risks to achieve big returns. But the best investors don’t fall for this high-risk, high-return myth. Instead, they hunt for investment opportunities that offer what they call asymmetric risk/reward: a fancy way of saying that the rewards should vastly outweigh the risks. In other words, these winning investors always seek to risk as little as possible to make as much as possible. That’s the investor’s equivalent of nirvana.

I’ve seen this up close with Paul Tudor Jones, who uses a “five-to-one rule” to guide his investment decisions. “I’m risking one dollar in the expectation that I’ll make five,” he explained to me in the early days of our coaching relationship. “What five-to-one does is allow you to have a hit rate of 20%. I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose.”

How is that possible? If Paul makes five investments, each for $1 million, and four in a row go to zero, then he’s lost a total of $4 million. But if the fifth investment is a home run and makes $5 million, he’s earned back his entire $5 million investment.

In reality, Paul’s hit rate is a whole lot better than that! Imagine that only two of his five investments pan out as expected and go up fivefold. That means his original $5 million has just grown to $10 million. In other words, he’s doubled his money despite, in this case, being wrong 60% of the time!

By applying his five-to-one rule, he sets himself up to win the game, despite some inevitable mistakes.

Now, let’s be clear: five-to-one is Paul’s ideal investment. He obviously can’t find that ratio every time. In some cases, the ratio of three-to-one is his target. The larger point is, he’s always looking for limited downside and huge upside.

Another friend of mine who’s obsessed with asymmetric risk/reward is Sir Richard Branson, the founder of the Virgin Group. Richard, who oversees about four hundred companies, isn’t just an inspired entrepreneur. He’s also an adventurer with a dangerous passion for putting his life on the line, from hot-air ballooning around the globe, to setting the record for the fastest crossing of the English Channel in an amphibious vehicle! So he’s the ultimate risk taker, right? Yes and no. It’s true that he takes outlandish risks with his life. But when it comes to his finances, he’s masterful at minimizing risk.

I’ll give you a classic example: when he launched Virgin Atlantic Airways in 1984, Richard started with just five airplanes. He was challenging an entrenched Goliath, British Airways, in an infamously tough business. He once joked, “If you want to be a millionaire, start with a billion dollars and launch a new airline!” But Richard spent over a year negotiating an unbelievable deal that would allow him to return those planes if the business didn’t pan out. That left him with minimal downside and limitless upside! “Superficially, I think it looks like entrepreneurs have a high tolerance for risk,” he says. “But one of the most important phrases in my life is ‘Protect the downside.’ ” This pattern of thinking about asymmetric risk/reward cropped up again and again in my interviews with famous investors. Consider Carl Icahn, whose net worth is estimated at $17 billion and who was dubbed “Master of the Universe” on the cover of Time magazine. This is a guy whose compounded rate of return since 1968 was 31%, better even than Warren Buffett’s 20%.I Carl earned a fortune by making huge investments in poorly run businesses and then threatening to take them over unless management agreed to mend its ways. This might seem like the world’s riskiest game of high-stakes poker, with billions on the line.

But Carl never lost sight of the odds. “It appeared that we were risking a lot of money, but we weren’t,” he told me. “Everything is risk and reward. But you’ve got to understand what the risk is and also understand what the reward is. Most people saw much more risk than I did. But math doesn’t lie, and they simply didn’t understand it.” Are you starting to see a pattern here? These three multibillionaires—Paul Tudor Jones, Richard Branson, and Carl Icahn—have totally different approaches to making money. Yet all three share the same obsession: how to reduce risks while maximizing returns.

Now, forgive me if I’m wrong. But I’m guessing that you’re not about to start a new airline or launch a hostile takeover of a company. So how can you apply this pattern of thinking in your own financial life?

One way to achieve asymmetric risk/reward is to invest in undervalued assets during times of mass pessimism and gloom. As you’ll learn in the next chapter, corrections and bear markets can be among the greatest financial gifts of your life. Think back to the financial crisis of 2008–09. At the time, it felt like hell on earth. But if you had the right mind-set and your eyes were open, the opportunities were heavenly! You couldn’t move without tripping over a bargain!

When the market hit rock bottom in March 2009, the future looked so bleak to most investors that you could snap up shares in blue-chip companies for pennies on the dollar. For example, Citigroup sank to a low of 97 cents a share, down from a peak of $57! You could literally own a piece of the company for less than it cost you to take money out of an ATM. But here’s the kicker: winter is always followed by springtime, and sometimes the seasons turn much quicker than you’d ever guess. This 97-cent stock shot to $5 within five months, giving investors a 500% return.

That’s why “value” investors like Warren Buffett lick their chops during bear markets. The turmoil enables them to invest in beaten-up stocks at such low prices that the downside is limited and the upside is spectacular.

Buffett did just that in late 2008, investing in fallen giants such as Goldman Sachs and General Electric, which were selling at once-in-a-lifetime valuations. Better still, he structured these investments in ways that reduced his risk even further. For example, he invested $5 billion in a special class of “preferred” shares of Goldman Sachs, which guaranteed him a dividend of 10% a year while he waited for the stock price to recover!

Most people get so scared during crashes that they see only the downside. But Buffett made sure that it was almost impossible for him to lose.

In other words, it’s all about asymmetric risk/reward!

Here is an example from my own personal investments. A window of opportunity opened up for me in the years following the 2008-09 financial crisis, when banks had decided to implement some of the most stringent lending requirements in years. At the time, many individuals had significant equity value in their homes but no way to access the funds. A refinancing, or re-fi, was out of the question. They were looking for a way to access short-term funds (typically one to two years or less) and were willing to post their home as collateral.

In short, I would lend them the funds they needed and became what is known as the “first trust deed holder” on their home. Back in 2009, a homeowner came to my team with a house valued at $2 million, and it was owned free and clear. He was requesting a $1 million loan (50% of the current appraised value of the property) and was willing to pay 10% interest for 12 months. Not bad in a world where I could invest in a 10-year Treasury note and currently earn only 1.8% a year. And since the Federal Reserve has already begun raising rates, that will put downward pressure on bond prices so my net return could be less (unless I am willing to hold all the way to maturity).

So what was my downside if I invested in the trust deed? If the borrower defaulted, the real estate market would have had to collapse by more than 50% for me to not get my money back. Even in the worst real estate downturn we’ve seen in over half a century (2008) this specific community did not see price decreases greater than 35%. So with a short one-year time horizon, this met the first of my criteria—how to increase my odds of not losing money!

Plus, look at the asymmetrical risk/reward: There was little risk of losing money, given that the real estate market could drop by 50% and I’d still break even; and a 10% annual return gave me plenty of upside in an environment of compressed returns. Based on these factors, I was confident that this investment offered an excellent balance of risk and reward.

Now you don’t need to have a million dollars to do investments like this. Many borrowers were asking for $25,000 to $50,000 loans as well. But my point here is not that you should go hunting for first trust deeds. There are other risks associated with these types of investments that are important to understand. The point is, different opportunities will always present themselves, depending on the economic climate or market behavior.

CORE PRINCIPLE 3: TAX EFFICIENCY

As we discussed earlier, taxes can easily wipe out 30% or more of your investment returns if you’re not careful. Yet mutual fund companies love to tout their pretax returns, obscuring the reality that there’s only one number that truly matters: the net amount that you actually get to keep.

When people congratulate themselves on their investment returns without taking into account the impact of taxes (let alone fees), what they’re really demonstrating is a gift for self-delusion! It’s a bit like saying, “I was so good on my diet today,” while conveniently forgetting that you scarfed down a couple of donuts, a double portion of French fries, and a hot-fudge sundae!

In investing, self-delusion is an expensive habit. So let’s remove the blindfold and confront the unvarnished truth! If you’re a high earner, you could currently be paying an ordinary income tax rate of 50% between federal and state taxes. If you sell an investment that you’ve owned for less than a year, your gains will be taxed at the same sky-high rate you pay on your ordinary income. Brutal, right?

By contrast, if you hold most investments for a year or more, you’ll pay long-term capital gains tax when you sell. The current rate is 20%, which is way lower than the rate you pay on your ordinary income. Simply by being smart about your holding period, you’re saving up to 30% on taxes.

But if you ignore the impact of taxes, you pay a heavy price. Let’s say you own a mutual fund that earns 8% a year. After deducting fees of, say, 2% a year, you’re left with 6%. If the fund trades frequently (as most funds do), then all those short-term gains will be taxed at your ordinary income rate.II So if you’re a high earner in a state such as California or New York, your 6% annual return just got cut in half to a measly 3% post-tax return! At this rate, you’ll double your money only every 24 years. But you also need to take into account the effect of inflation. If that comes in at 2% a year, your real return has just dropped from 3% to 1%. At this rate, you’re likely to retire at the age of 120.

I have enough money to retire and live comfortably for the rest of my life. The problem is, I have to die next week.

—ANONYMOUS

Now can you see why it’s so important to invest in a tax-efficient way? Believe me, all the billionaires I’ve ever met have one attribute in common: they and their advisors are really smart about taxes! They know that it’s not what they earn that counts. It’s what they keep. That’s real money, which they can spend, reinvest, or give away to improve the lives of others.

In case you’re wondering, there’s nothing sordid or immoral about managing your finances in ways that lawfully reduce your tax burden. The authority most often quoted on this subject by legal scholars and the US Supreme Court is Federal Appeals Court Judge Billings Learned Hand. He famously stated in 1934: “Anyone may arrange his affairs so that his taxes shall be as low as possible. . . . Nobody owes any public duty to pay more than the law demands.” When I met David Swensen, he pointed out that one of his biggest advantages in investing money for Yale is that it’s a nonprofit institution and thus exempt from taxes. But what should the rest of us do? First, steer clear of actively managed funds, especially those that trade a lot. As David told me, one benefit of index funds is that they keep trading to a minimum, which means “your tax bill is going to be lower. This is huge. One of the most serious problems in the mutual fund industry, which is full of serious problems, is that almost all mutual fund managers behave as if taxes don’t matter. But taxes matter. Taxes matter a lot.” As he spoke, I could feel his deep concern, his determination to help people understand the significance of what he was saying. The enormous impact of taxes on your returns “speaks to the importance of taking advantage of every tax-advantaged investment opportunity that you can,” David emphasized. “You should maximize your contributions if you’ve got a 401(k), or a 403(b) if you work for a nonprofit. You should take every opportunity to invest in a tax-deferred way.” It sounds so obvious, right? We all know that tax-advantaged vehicles such as 401(k)s, Roth IRAs, traditional IRAs, private placement life insurance (or PPLI, the “rich man’s Roth”), and 529 plans (for college savings) can help us reach our goals quicker. You’re probably taking advantage of some of these opportunities already. But if you’re not maximizing your contributions, now is the time to do it!

If you want to learn more about this topic, Money: Master the Game covers it in depth in chapter 5.5: “Secrets of the Ultrawealthy (That You Can Use Too!).” Remember: one problem you’ll encounter if you’re using a broker is that they are not tax professionals, so they’re not allowed legally to advise you on taxes. Even most registered investment advisors don’t have a tax expert on their team to guide you in this area. That’s why you ideally want to partner with a firm that has CPAs on staff, since they’ll keep tax efficiency top of mind.

I’ve applied what David taught me. This tax-sensitive way of thinking permeates my approach to investing. Of course, I don’t start with taxes. That would be a severe mistake. I always start with a focus on not losing money and on getting asymmetric risk/reward. Then, before making any investment, I make a point of asking, “How tax efficient is this going to be? And is there any way we could make it more tax efficient?” One reason for this obsession is that I spent much of my life living in California, where—after tax—I kept as little as 38 cents of every dollar I earned. When you’re taxed that heavily, it sensitizes you pretty quickly! I learned to focus solely on what would be left after paying Uncle Sam his due.

Whenever someone tells me about a financial opportunity that seems to offer enticing returns, my response is always the same: “Is that net?” More often than not, the person replies, “No, that’s gross.” But the pretax figure is phony, whereas the net number doesn’t lie. Your goal, and mine, is always to maximize the net.

I’ll give you a specific example: Creative Planning, where I serve as chief of investor psychology, might recommend master limited partnerships (MLPs) for certain client portfolios, when appropriate. As I soon learned, these publicly traded partnerships offer an easy way to invest in energy infrastructure such as pipelines for oil, gasoline, and natural gas. I called my friend T. Boone Pickens, who’s made billions in the oil business, and asked, “What do you think of MLPs right now?” He explained that their price had tumbled because of a crash in energy prices. In fact, from 2014 through early 2016, the price of oil had fallen more than 70%. Many investors assumed that this drop was terrible news for MLPs, since they provide infrastructure to clients in the energy business. But MLPs—at least, the best of them—are much better protected than they seem. That’s because their clients typically sign long-term contracts with fixed fees in return for the right to use this infrastructure. This provides a reliable income stream year after year, enabling MLPs to pay out generous royalty income to their partners.

As Boone explained, you’re not really betting on oil and gas prices when you invest in an MLP. As an owner of a pipeline, you’re more like a toll collector. Regardless of what happens to oil or gas prices, energy is going to keep getting transported around the country, because it’s the lifeblood of the national economy. And, as an owner of the MLP, you’ll keep collecting your tolls like clockwork!

Meanwhile, the fact that the price of MLPs had nosedived was actually good news for investors. Why? Because this was an overreaction to the drop in the price of energy. Most investors were so fearful, that you could invest at a historically low valuation. Even some of the highest-quality MLPs had seen their prices fall 50%.

But the tollbooth was still working beautifully. An MLP that had sold previously for $100 paid an annual income royalty of $5 per share—that’s 5% income per year on the investment. When the price dropped to $50, the MLP still paid out $5 per share of income. But this now amounted to a 10% annual income return! That might not sound like a bonanza. But in this era of rock-bottom interest rates, it’s a whole lot better than bonds that yield 2% or less. Even better, you still had all of the upside if the price of the MLP recovered!

So let’s take a moment and see how MLPs stacked up against the criteria in our Core Four:

  1. Don’t Lose. The price of energy and MLPs had fallen so much that it was unlikely they’d fall significantly further. Experts like “the oil oracle” T. Boone Pickens also pointed out that energy production had shrunk massively because prices had cratered. That meant supplies were diminishing, and even with lesser demand, the prices would eventually have to rise. With all this on your side, the odds of losing money were greatly diminished.

  2. Asymmetric Risk/Reward. As we’ve said, there was very little risk of loss. But there was a high probability that energy prices would eventually recover and that MLPs would return to favor. In the meantime, you’d be collecting 10% a year in annual income. Believe me, I’m happy to sit tight and collect my tolls!

  3. Tax Efficiency. But here’s the best part: the US government needs to promote domestic energy production and distribution, so it has given MLPs preferential tax treatment. As a result, most of the income you receive is offset by depreciation, which means that roughly 80% of your income is tax free. So if you make a 10% return, you’re netting 8% annually. That’s pretty nice, right? By contrast, if you didn’t have this tax-preferential treatment, the income paid within the year would be taxed at your ordinary income tax rate. A high income earner who pays 50% in taxes would net just 5%. In other words, by using the tax efficiency of an MLP, you net 8% instead of 5%. The difference: 60% more money in your pocket. That’s the power of tax efficiency.

As Peter will explain in the next chapter, MLPs aren’t right for everyone—nor are we specifically recommending them for you. But it’s the broader principle that I’m looking to illustrate here: by focusing on after-tax returns, you can put yourself on a much faster path to financial freedom.

Incidentally, it’s worth pointing out that there’s almost always an asset class or a country or a market that’s getting clobbered, presenting you with equally enticing opportunities for asymmetrical risk/reward.

Finally, for good measure, being smart about your taxes also helps you to have a greater impact on the world. Instead of leaving the government to decide how to spend your money, you get to decide for yourself! My own life is infinitely richer because I’m able to support causes that excite and inspire me. I’ve been able to provide a quarter of a billion free meals so far, and I’m on my way to a target of one billion meals through my initiative with Feeding America. I’m also providing 250,000 people with fresh water every day in India, and I’m helping to save over 1,000 kids from sexual slavery through a partnership with Operation Underground Railroad.III These are just a few of the gifts I can share as a result of being tax efficient in my investments.

CORE PRINCIPLE 4: DIVERSIFICATION

The fourth and final principle in the Core Four is perhaps the most obvious and fundamental of all: diversification. In its essence, it’s what almost everyone knows: don’t put all your eggs in one basket. But there’s a difference between knowing what to do and actually doing what you know. As Prince-ton professor Burton Malkiel told me, there are four important ways to diversify effectively: 1. Diversify Across Different Asset Classes. Avoid putting all your money in real estate, stocks, bonds, or any single investment class.

  1. Diversify Within Asset Classes. Don’t put all your money in a favorite stock such as Apple, or a single MLP, or one piece of waterfront real estate that could be washed away in a storm.

  2. Diversify Across Markets, Countries, and Currencies Around the World. We live in a global economy, so don’t make the mistake of investing solely in your own country.

  3. Diversify Across Time. You’re never going to know the right time to buy anything. But if you keep adding to your investments systematically over months and years (in other words, dollar-cost averaging), you’ll reduce your risk and increase your returns over time.

Every Hall of Fame investor I’ve ever interviewed is obsessed with the question of how best to diversify in order to maximize returns and minimize risks. Paul Tudor Jones told me, “I think the single most important thing you can do is diversify your portfolio.” This message was echoed in my interviews with Jack Bogle, Warren Buffett, Howard Marks, David Swensen, JPMorgan’s Mary Callahan Erdoes, and countless others.

The principle itself may be simple, but implementing it is another matter! That requires real expertise. This is such an important topic that we’ve devoted much of the next chapter to it. My partner, Peter Mallouk—who guided his clients through the frightening crash of 2008–09—will explain how to build a customized asset allocation, diversifying among different types of investments such as stocks, bonds, real estate, and “alternatives.” His mission: to help you construct a portfolio that will enable you to prosper in any environment.

This might sound like a big promise, but diversification does its job in the worst of seasons. Between 2000 and the end of 2009, US investors experienced what has become known as the “lost decade” because the S&P 500 was essentially flat despite its major swings. But smart investors look beyond just the largest US stocks. Burt Malkiel authored a Wall Street Journal article titled “ ‘Buy and Hold’ Is Still a Winner.” In it he explained that if you were diversified among a basket of index funds—including US stocks, foreign stocks, and emerging-market stocks, bonds, and real estate—between the beginning of 2000 and the end of 2009, a $100,000 initial investment would have grown to $191,859. That’s a 6.7% average annual return during the lost decade!

One reason why diversification is so critical is that it protects us from a natural human tendency to stick with whatever we feel we know. Once a person is comfortable with the idea that a particular approach works—or that he or she understands it well—it’s tempting to become a one-trick pony! As a result, many people end up investing too heavily in one specific area. For example, they might stake everything on real estate because they grew up seeing it work like magic for their family; or they might be a gold bug; or they might bet too aggressively on a hot sector such as tech stocks.

The trouble is, everything is cyclical. And what’s hot can now suddenly turn to ice. As Ray Dalio warned me, “It’s almost certain that whatever [asset class] you’re going to put your money in, there will come a day when you will lose 50%–70%.” Can you imagine having most or all of your money in that one area and watching in horror as it goes up in flames? Diversification is your insurance policy against that nightmare. It decreases your risk and increases your return, yet it doesn’t cost you extra. How’s that for a winning combination?

Of course, there are many different ways of diversifying. I discuss this in detail in Money: Master the Game, laying out the exact asset allocations recommended by Ray and other financial gurus, such as Jack Bogle and David Swensen. For example, David told me how individual investors can diversify by owning low-cost index funds that invest in six “really important” asset classes: US stocks, international stocks, emerging-market stocks, real estate investment trusts (REITs), long-term US Treasuries, and Treasury inflation-protected securities (TIPS). He even shared the precise percentages that he would recommend allocating to each.

As for Ray Dalio, his unique approach to diversification does an extraordinary job of taming risk. I had the privilege of speaking right after my dear friend Ray at the Robin Hood Investors Conference in late 2016. The best investors in the business listened intently as Ray revealed one of the great secrets of his approach: “The holy grail of investing is to have 15 or more good—they don’t have to be great—uncorrelated bets.” In other words, everything comes down to owning an array of attractive assets that don’t move in tandem. That’s how you ensure survival and success. In his case, this includes investments in stocks, bonds, gold, commodities, real estate, and other alternatives. Ray emphasized that, by owning 15 uncorrelated investments, you can reduce your overall risk “by about 80%,” and “you’ll increase the return-to-risk ratio by a factor of five. So, your return is five times greater by reducing that risk.” I’m not suggesting that there’s a perfect, one-size-fits-all approach that you should necessarily follow. What I really want to convey is that all of the best investors regard diversification as a core component of long-term financial success. If you follow their example by diversifying broadly, you’ll be prepared for anything, freeing you to face the future with calm confidence.

READY TO RUMBLE!

By now, you’re already way ahead of the game. You belong to a tiny elite that understands these four all-important principles that the best investors use to guide their investment decisions. If you live by them, your odds of investment success will rise exponentially!

In the next chapter, we’ll delve deeper into the nitty gritty of asset allocation. Peter Mallouk will explain the benefits of taking a customized approach that’s tailored to your specific needs and circumstances. With his expert guidance, you’ll learn to construct a diversified portfolio that enables you to weather any storm. Remember: we all know that winter is coming. We all know that bear markets are regular occurrences. Most investors live in fear of them. But you’re about to discover how to make winter the best season of all—a season to relish!

So come with me, intrepid warrior! It’s time to grab our weapons and slay the bear!

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