Whether you are a do-it-yourself investor or you work with an adviser, there are several basic principles you should be aware of that can help improve your investment performance. Even though many of these are considered ‘common sense’ by those who are educated about investing, not everyone is aware of these important principles. If you are just starting out or if you are working with brokers and other advisers who are primarily making money from either selling products or charging asset-based fees, you will need to educate yourself to avoid making costly mistakes. Here are top five principles of investment management that you should know about:

1) Use low cost index funds.

Index funds represent stock market indices, such as S&P500, and generally contain a large number of different stocks. Not all market indices are available to buy as index funds, but as of today, many are. Index funds typically cost no more than about 0.3% (this can be higher for more exotic asset classes such as foreign small capitalization stocks), but for domestic stocks, the index funds charge as low as 0.05%. Compare this to 1% that is charged by many managed funds – this difference might eat away hundreds of thousands out of your portfolio returns. When it comes to bond funds, not all are index funds – some have to be actively managed, but the expense ratio will give a clue whether this is an actively managed ‘index’ with a specific allocation that rarely (if ever) changes, or an actively managed bond fund that does not stick to a specific allocation. Most bond index funds cost around 0.3% or less to manage, with Vanguard bond funds charging as low as 0.06%). A bond index fund sticks closely to their stated purpose without venturing in and out of various types of bonds, as do actively managed bond funds, which can lead to higher risk and lower performance all at a higher cost. For example, an Aggregate Bond or an Intermediate Treasury bond funds have an allocation they always stick to, and they can always be expected to track an index or a predetermined allocation. It is possible for a bond index fund to make some changes to its allocation (such as the range of maturities for Treasury bond funds), but these changes are usually relatively small, and they are announced in advance. Actively managed funds not only charge higher management fees, but they can also significantly underperform market indices when the manager makes mistakes (especially during the times of market turbulence), so it is always best to use index funds.

2) Diversify across multiple asset classes

US stocks account for less than 50% of the global stock market, so a good exposure to global stocks is important. Some popular asset classes include domestic large cap and small cap stocks, international large cap and small cap stocks, emerging markets and real estate. There are also dividend-paying stocks (sometimes called ‘value’ stocks) available in many asset classes. The reason to include dividend-paying stocks in your portfolio is because dividends account for a good portion of long-term returns (about 40% for S&P500 long-term returns as of 2009). Let’s also not forget bonds – it is essential to diversify your portfolio with high quality bonds (more on this below). When diversifying in a retirement plan, always make sure that your investments truly belong to different asset classes – when you put your money into 10 different funds and they are essentially the same asset class (usually domestic large cap) this will not provide any diversification benefits.

What is the benefit of diversification? If we are exposed to a single asset class, we are tied to the performance of this asset class only. When we have multiple asset classes we get the benefit of ‘average’ performance – while one asset class is down, another one might be up, so during normal market conditions (when everything is not going down at once), this allows us to get average returns of the entire market. Over the long term it is not possible to consistently beat the market (statistically, it is a certainty that a small number of investors can do it, but it always happens in hindsight – nobody is able to predict exactly who will beat the market), so getting market returns is actually much easier than trying to beat it (and fail). Historically, market returns have been pretty good, and though there is no reason to expect the same returns going forward, this is the best we can do investing in index funds. We can, however, over-weigh various asset classes that are more volatile/risky in the hope of getting returns higher than the market (in this case, the “market” is usually represented by the S&P500 index), but one has to be very careful because such a portfolio can also fall more than S&P500 during market crashes.

3) Minimize investment expenses

Morningstar showed that lower-costing mutual funds outperform higher costing ones. This fact leads us in the direction of index funds vs. higher costing managed funds. So it is critical to minimize investment expenses as that adds to our total return. An extra 1% in expenses can cost your portfolio hundreds of thousands, and possibly significantly more if your investment is inside a retirement plan, as small practice retirement plans have some of the highest asset-based fees. Often, asset-based advisory fees are charged in addition to high mutual fund fees, so overall asset-based fees of over 2% are not uncommon. Doctors and dentists will accumulate large portfolios, so minimizing investment fees is extremely important. It is also critical to avoid paying excessive asset-based (AUM) fees for investment advice, including paying asset-based fees for management of index fund portfolios.

4) Manage downside risk

Everyone knows that stock market is risky, but we don’t have a good measure of this risk. What we see is volatility, which is a manifestation of risk. Higher volatility means higher risk, yet there is more to risk than just the volatility. While a riskier portfolio might generate higher returns, it can also have lower returns than a portfolio that is less risky. This might not be very obvious when the markets go up, but this becomes very clear when the markets fall. It is very important to understand this tradeoff and why you might want a balanced portfolio that can generate ‘good enough’ returns with less volatility vs. trying to have a high risk portfolio with a potential for large losses.

The best way to manage portfolio risk is to use high quality fixed income, whether bond mutual funds or individual bonds. Some types of bonds (such as municipal bonds, which generate tax-free interest) can be purchased in after-tax accounts. Other bonds, such as Treasuries (with taxable interest), are best purchased inside tax-sheltered accounts. While bonds might not seem like a high-flying asset class, since 1970s bonds returned as much as 7% annually with minimal risk vs. stocks, so it is always a good idea to include some bonds in your portfolio.

While you might have a high risk tolerance when markets are going up, when markets start to slide as much as 50% you might have second thoughts about holding on, so to avoid making investment mistakes, keeping a portion of your portfolio safe might be a good idea. This approach makes risk management rather simple – you do not invest in stocks what you do not want to lose.

5) Create a long term plan that addresses your entire financial situation, not just your investments, and stick to it, making changes only when financial situation calls for it.

This one is a no-brainer. While everyone’s finances might experience changes, it is important to be proactive in addressing them. Doctors and dentists make a lot of money, but they also have to pay a lot in taxes, so planning your tax liability (and minimizing it) is key. Most doctors and dentists will have the majority of their assets in retirement plans, so it is critical to open the right type of plan for your practice.