Ray Dalio has become a folk hero. His No. 1 New York Times best-seller “Principles: Life and Work” was released to rave reviews from such luminaries as Bill Gates, Michael Bloomberg, and even Tony Robbins. The tome is chock-full of wisdom gleaned from building an investment fund from humble beginnings in his apartment to over $140 billion under management. This journey earned the son of a jazz musician and stay-at-home mom a massive net worth of over $12 billion, making him among the wealthiest investors on earth.

While “Principles” is not an investment tome per se, Dalio has been very upfront with his investing philosophy and method over the years.

#-ad_banner-#Having studied how Dalio was able to pull off such an incredible growth story, I have distilled Dalio’s investment philosophy into five rules that every investor can apply.

1. Diversify
While diversifying your investments may sound obvious, Dalio’s take on the subject is specific and unique.  

His diversification strategy is based on the principle of reality.  

This principle teaches to always see the world for what it is and not what you wish it to be. In investing, the reality is that many of your investment choices are going to provide lackluster returns and even lose money. Many investors do not see truth when choosing investments and become delusional about the worth of particular investments and their investment choosing ability. Even with Dalio’s massive research team he still does not know what the future holds, that is a reality! This reality forces the diversification rule to be critical for long-term investment success.

Specifically, Dalio believes that it takes 15 uncorrelated investments to reduce the risk factor by 80%.

“I think the important thing here if I’m an investor is that the most important thing you can have is an excellent strategic asset allocation mix,” Dalio says. “In other words, you’re not going to win by trying to get what the next tip is — what’s going to be good and what’s going to be bad. You’re definitely going to lose. So, what the investor needs to do is have a balanced, structured portfolio — a portfolio that does well in different environments.”

Investors can diversify across and within asset classes, geography, currencies, markets, and even time.  

2. Understand Inflation Risk
Dalio’s next primary investment rule is to balance your portfolio based on inflation risk. Inflation has a considerable impact on financial markets. Knowing how to optimize your portfolio regardless of inflationary shifts is a key to consistent returns over time.

Once again the principle of reality comes into play as he does not try to predict deflation and inflation pressures. Rather, by viewing the data through a prism of knowing the current economic environment, a balanced portfolio can be designed.

Dalio explains it best: “Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of growth, and cash will be the most attractive when money is tight.  Translation: all asset classes have environmental biases. They do well in certain environments and poorly in others. As a result, owning the traditional, equity-heavy portfolio is akin to taking a huge bet on stocks and, at a more fundamental level, that growth will be above expectations.”

3. Don’t Have Any Biases
More investors are wiped out by holding onto positions due to bias than any other reason.  Bias is a real account killer.

Most investors have a bullish or bearish bias when approaching the market.  

These biases result in investors holding positions too long and making investments not based on reality.  The best way to avoid biases is to go back to Rule No. 1 — diversify!

4. Sell The Winners, Buy The Losers
Dalio teaches to take profits on fully priced stocks. This means not to continue to hold stocks after substantial gains but instead sell them to reinvest the profits. The gains should be reinvested into good companies whose share price has lagged the sector or market. He calls this “rotating the portfolio.” Investors often make the mistake of holding on to large winners even after the winning streak ends. It is much better to take profits and rotate into good companies whose prices have not rocketed higher. Dalio firmly believes that the higher the price of an investment, the less likely the price will continue to climb.

5. Learn What Moves Interest Rates
A famous quote from Ray Dalio is: “It all comes down to interest rates. As an investor, all you’re doing is putting up a lump-sum payment for a future cash flow…. The big question is:  When will the term structure of interest rates change? That’s the question to be worried about.  He who lives by the crystal ball [in trying to forecast interest rates] will eat shattered glass.”

In other words, don’t try to predict interest rates; rather, understand their structure and why they move.  

Risks To Consider: Risk is persistent in the financial markets.  Even Ray Dalio has losing investments.  Always use stops and position size properly when investing.

Action To Take: Read “Principles” with an eye toward applying the wisdom to investment decisions.