1.  

Investors inherently avoid risk. Investors are often more concerned with risk than they are with reward. Rational investors are not willing to accept risk unless the level of return compensates them for it.

2.  

Securities markets are efficient. The "Efficient Market Hypothesis" states that while the returns of different securities may vary as new information becomes available, these variations are inherently random and unpredictable. Assets are re-priced every minute of the day according to what news comes out. As new information enters the market, it is quickly absorbed into the prices of securities, and thus hard to capitalize on. In fact, advancing information technology and increased sophistication on the part of investors are causing the markets to become even more efficient.

The implications of the Efficient Market Hypothesis are far-reaching for investors. It implies that one should be deeply skeptical of anyone who claims to know how to "beat the market." One cannot expect to consistently beat the market by picking individual securities or by "timing the market".

The Efficient Market Hypothesis is at odds with traditional investment strategies. It has, however, been supported by numerous academic studies, both theoretical and empirical. These studies show, among other things, that the risk-adjusted returns achieved by professional investment managers are no better than those of the market as a whole. This was primarily due to the expenses and taxes incurred with active management. That's the bad news. The good news is that the rate of return of the capital markets is darn good (10%+ over time).

3.  

Focus on the portfolio as a whole and not on individual securities. The risk and reward characteristics of all of the portfolio's holdings should be analyzed as one, not separately. An efficient allocation of capital to specific asset classes is far more important than selecting the individual investments.

As the pie chart shows, your asset allocation can determine over 90% of the performance variation of your investment portfolio. How your investment dollars are allocated far outweighs the potential effects of individual security selection and market timing.

4.  

Every risk level has a corresponding optimal combination of asset classes that maximizes returns. This is called the "Efficient Frontier". Portfolio diversification is not so much a function of how many individual stocks or bonds are involved, but the relationship of one asset to another. We call this relationship "correlation". The higher a correlation between two investments, the more likely they are to move in the same direction.

The efficient frontier represents the range of hypothetical portfolios that offer the maximum return for any given level of risk. Portfolios positioned above the range are unachievable on a consistent basis. Portfolios below the efficient frontier are inefficient portfolios (too much risk, not enough reward). The ideal portfolio exists somewhere along the efficient frontier.

The portfolio represented by point A is inefficient because portfolios exist with the same value but less risk (Portfolio B) and portfolios with the same risk but more value (Portfolio C) as well as portfolios with a combination of these two conditions. The Efficient Frontier, as originally defined in Modern Portfolio Theory, is a line that represents the continuum of all efficient portfolios.

1.  

Exposure to the overall market (beta).

2.  

The percentage invested in large company stocks versus small company stocks. Over time, small company stocks have higher expected returns than large company stocks. This is because stocks of small companies are riskier than those of large companies and investors demand a premium for this risk. For a more in-depth look at how this works read Scott A. Leonard's article from Financial Planning magazine "The Smaller, the Better."

3.  

The percentage invested in growth stocks versus value stocks. Over time, value stocks have higher expected returns than growth stocks. Value stocks are those that sell at lower prices relative to their earnings and book values. They are perceived by investors to be riskier than growth stocks and investors demand a premium for this risk as well. Scott A, Leonard elaborates on how this works in his article "The Dogs of the Dogs" published in Financial Planning magazine.