The Flaw in Ray Dalio’s Investing Strategy

Ray Dalio

I’m a huge Ray Dalio fan.

Ray is one of the most famous investors in history, the founder of Bridgewater the largest hedgefund in the world with around $160 billion in assets under management as of writing this article.

He’s a brilliant thinker and one of the thought leaders when it comes to asset allocation and portfolio construction.

His firm is perhaps most famous for accurately predicting the 2008-2009 financial collapse as well as the European debt crisis, gaining positive returns when most lost money in 2008-2009 then having phenomenal returns in 2010 and 2011.

But history lies to us and it’s easy to focus on those big wins ignoring the 4.5%/year returns Bridgewater has produced between 2012 and 2017 when the world markets have enjoyed an incredible bull run.

With all the talk about Ray it’s worth examining what works and what doesn’t work, not so much for Bridgewater but for people like you and I in looking at them for investing lessons.

They’ve Got a Terrible Record of Macro Calls

It’s worth noting that as much as I love Ray and love his thinking you should be aware of what he’s good at.

He’s got very solid research into the transactions behind markets.

He’s got excellent logical thinking.

On the flip side his calls about what the broader market (not necessarily the economy) would do have been way off. For example, Bridgewater predicted a huge drop in the stock market if Trump won the election…the opposite happened.

He said they wouldn’t continually raise interest rates referring to “one then done”. They’ve raised over and over.

The list goes on. At least recently his calls about what would happen haven’t been great and it reflects in their investing performance.

Most recently at the Davos Conference 2018 he said anyone who was in cash over the next little while would feel stupid because the market was going to surge. We’ll see if he proves right or not.

A lot of very smart people including some of our hedge fund manager and investor clients think he’s way off.

Be Aware Dalio Prioritizes Risk – Meaning Volatility

Before we get into the specifics of where Dalio has taught me a lot and also where his system breaks down for most investors, it’s worth considering the angle he comes at it with.

His background is largely in helping companies hedge against risk.

He’s done some great work in this regard and his strategies both in the Pure Alpha fund and his All Weather fund are designed to minimize risk.

When he says “risk” he actually means “volatility” or “beta”, which is different from what most people think of when they think of risk as we’ve discussed in previous articles.

So, his strategies will inevitably have lower peaks and lower valleys in their returns. In the abstract this means they’ll take 40% return instead of 70% return, so they can have 5% return instead of 20% loss in another year.

Their clients are mostly very large institutions, corporations and governments who value this investment profile and of course it pays off big in times of crisis…we just haven’t seen one of those in a while.

What I Learned From Dalio

Dalio famously created the video How the Economic Machine Works, which is brilliant and fantastic though incomplete in its overall explanation and therefore not overly useful to the average person, though it remains fascinating and I recommend it often.

He was also famously interviewed in Tony Robbins book Money Master the Game talking in particular about portfolio theory, asset allocation and something called Risk Parity, which they created and has now become very common within the fund management world.

Prior to Dalio I was much more anti-diversification than I am today. He really was a dominant force in helping me to understand the value of asset allocation and diversification though I’m still far more bullish on concentrated portfolios than financial advisors and other people who I generally consider pretty useless because they can’t beat the market.

Dalio’s 3 Ways to Beat the Market

Dalio’s approach is to suggest you can beat the market in 3 ways (you’ll notice these are different from the 4 ways to beat the market we discuss at Richucation though if you dig deeper they tend to overlap):

  1. Beat on selection – pick assets that outperform
  2. Beat on timing – buy and sell to take advantages of ups and downs better than the market
  3. Beat on asset allocation – by leveling out the volatility you multiply your compounded returns over time

His argument is the first two of very hard to do because in the markets you’re competing with the big guys who have more resources than you. 

We of course disagree with this assessment because:

  1. Just because something is hard doesn’t mean it shouldn’t be done especially when the long-term gains are massive
  2. Individual investors have structural advantages over major investors that allow them to not have to compete with those big players. For example you’re not competing with Warren Buffett because Buffett can’t do a deal under $1 billion

His argument is it’s easier to beat the market on asset allocation.

I’m not sure this is true in terms of the “easier” part but it is certainly true that by choosing the right asset allocation mix you can level off returns, multiply returns and do very well.

This also has a huge psychological advantage since psychology kills most investors.

The Advantage We Love About Non-Correlated Asset Allocation

A major advantage to non-correlated asset allocation and the reason we work with larger clients on it is because it puts you in a position to take advantage of opportunities that aren’t available if you’re using a concentrated strategy.

What does this mean?

Well there are often times when an asset class, region, etc. is down and it’s a great opportunity to buy.

The problem is a big part of the reason to opportunity exists is because people don’t have money because it’s down.

If you diversify across non-correlated assets then when something drops a lot you can sell something else that’s up in order to take advantage of the asset that’s down.

This is super beneficial not just in investing but also in business, which is why we pay a lot of attention to it in Stage 4 and especially Stage 5 businesses.

Correlation Between Asset and Asset Class Performance

Dalio points out the majority of the returns in any given asset are mostly explainable by the asset class itself anyway.

For example, stocks tend to move up together. When the stock market is in a bull market 70% or so of stocks will go up not so much because of how great an individual stock is but they get swept along in the “rising tide raising all ships” approach.

Because the majority of the rise or fall in a stock can be explained by the class it’s in Dalio would argue it makes more sense to focus on the asset class than the individual asset (note this is fundamentally the opposite of Buffett who makes highly concentrated picks looking for companies that will outperform their asset class).

There’s a more important consideration when it comes to risk though.

People tend to diversify by say buying a basket of stocks rather than a given stock.

But the basket tends to do roughly the same thing as the individual items anyway so you don’t gain much of a diversification advantage operating that way.

What’s much better in terms of leveling out returns is to choose non-correlated (meaning they don’t more together) assets.

This is central to Dalio’s premise and also where his system breaks down for average people who want to beat the market. You’ll see it fits with our argument that Diversification is often Diworsification.

This isn’t to say there isn’t an advantage of diversifying within a region, asset class, etc. there can still sometimes be an advantage against certain rare events for example by having multiple houses you decrease your risk of a fire taking any one of them out because you’ll have others to protect you in the meantime.

What it means is your houses in the same city are likely to perform more or less the same so the volatility in your portfolio is likely to remain about the same as if you had just one.

Certainly, the argument is beyond some basic diversification you do little to decrease your volatility by diversifying within a given class.

What Ray shows is because risk has a dramatic affect on your overall portfolio returns by choosing a few non-correlated investments rather than correlated ones you can dramatically improve the performance of your overall portfolio without decreasing the returns.

Whereas if you bought a series of correlated assets you wouldn’t gain anything in terms of returns or decrease your risk.

At least on the surface this is true…it doesn’t always work that way for most people though and not even for Bridgewater, which will explain in a moment why Buffett gets better returns consistently than Dalio does.

Where Dalio’s Strategy Breaks Down

Dalio’s theory of boosting portfolio returns by decreasing volatility by choosing non-correlated assets is based on one very important underlying assumption that’s almost never true.

It assumes each of those non-correlated bets has the same returns as the correlated bets.

Think of it this way.

If I can choose between 10 options all of which have roughly the same returns but 2 are non-correlated and the other 8 are correlated what’s my best approach?

I should choose one of the 8 plus the other two so I end up with 3 non-correlated assets.

This is because they’ll level each other out decreasing volatility, which increases return, it will dramatically decrease risk and yet my returns won’t suffer because their returns were all roughly the same anyway.

The problem is how often do you have a bunch of non-correlated strategies with the same expected returns?

Almost never.

There’s two reasons for this:

  1. Markets tend to operate in cycles and what assets do well will be based in part on what stage they are at in the cycle. Since non-correlated assets tend to be at different stages in their respective cycle you’ll usually have to take a hit in returns to diversify out of one cycle and into another.
  2. People generally get superior returns by having expertise in a particular area for example in a particular region, asset class, etc. Virtually no one is an expert in many asset classes. So to diversify into different asset classes means moving away from areas where you’re an expert and into areas where you’re not an expert, which has a high likelihood of decreasing your overall returns.

Note, these observations aren’t based on the Wall Street theories these are based on the cold harsh realities of how real returns work in the real world not how some academic has generalized that they work.

This is where Dalio goes wrong.

In his book Principles he states he’s got hundreds of non-correlated strategies with similar expected returns and therefore they can diversify between those strategies decreasing risk, boosting returns without hurting returns.

But this hasn’t been true based on their real-world portfolio performance where Bridgewater has radically lagged the S&P 500 from 2012 to 2017…that’s a lot of opportunity cost and probably has meant even with their superior performance in 2010 and 2011 they probably don’t have a real edge in fact there’s a good chance they might be down relative to the general market.

Granted they might have done so with lower volatility, which might meet the mandate of their clients but it doesn’t do a lot for the average person working to get superior returns.

What Can You Do About It?

This isn’t merely a discourse in vanity we want to identify flaws in arguments in order to make better decisions.

So, what can we learn from this process?

First, we could argue concentration still beats diversification if you know what you’re doing.

Second, and perhaps more importantly you can still gain advantages similar to what Dalio is talking about by broadening your investing expertise.

What do I mean by this?

Start by mastering one asset class, one approach, one market.

But then rather than sticking to that one start mastering another that’s not correlated with the first.

So often someone who has expertise in real estate will expand by going into real estate in another market. Of course, they need to learn that market, network there etc. and usually it correlates fairly tightly with the first.

Or maybe they do something similar with companies and stocks.

Instead of doing that, which has diminishing returns anyway take the time to learn to master 2-3 other strategies, other markets, other asset classes not correlated to the first.

This way you’re in a position to invest in non-correlated assets without compromising your overall returns.

You can practice a great asset allocation strategy where you sell off what’s up to buy what’s down in cases where you can predictably find great opportunities and benefit from the best of both worlds.

This is why in our Multiply Ownership training we explain details of how the various major asset classes work so you can take advantage of multiple of them.

Some of the same fundamentals apply but you get to learn the nuances.

Taking this training is a great place to start but alternatively reach out to us take advantage of our network, our expertise, our deal flow to maximize your non-correlated returns.

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