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Investment Strategy Part III: Ray Dalio: The Past Predicts the Present
Lessons from the biggest hedge fund’s founder.
Lessons from the biggest hedge fund’s founder.
Ray Dalio is an American economist and investor, founder of Bridgewater Associates, the largest hedge fund in the world.
Dalio has been spending the last 50 years coming up with an economic model that measures all variables of the economy to predict the mid and long-term direction of markets.
His strategy isn’t based as much on the potential for an investment as it is on its past performances.
Indeed, Ray Dalio noticed that the events and crises we’re seeing in this world have already happened before, and that by studying the past, we can predict the future.
Here’s his strategy.
1. Understanding How The Economy Works
Ray has a simple way of understanding how the economy works.
He observed that anyone’s spending was someone else’s income. The money you spend at the bakery is the salary of the baker, for example.
The more people spend in the economy, the higher everyone’s salaries, so the more money people will spend.
Where does this increase in spending come from? From two sources: increase in productivity, and debt.
When people produce more within an equal time (due to new, better technologies), they earn more money, so they can spend more money.
But productivity remains stable over time, and does not make as big of a difference as before.
So the economy is mainly stimulated by debt.
People that borrow money (borrowers) have more money to spend, which stimulates the economy. In the short term, it’s good. The economy expands.
But comes the time when they have to refund, so they spend less money, so the economy slows down.
This cycle is the short-term debt cycle. On average, the economy expands for eight years, then recesses (when people need to repay their loans), then expands again.
The problem with debt is that it’s never fully repaid, but serviced by more debt. Many need to borrow to repay their loans.
Obviously, this can’t continue forever.
So this cycle busts roughly once every 75 years.
This is the long-term debt cycle.
Dalio constantly looks at where we’re at in the cycle and invests accordingly.
2. Beware of Biases
At the beginning of the 1980s, Dalio bet that the US would head into a recession.
Unfortunately, he was wrong. The next 18 years saw formidable non-inflationary growth in America.
He lost his entire fortune as a result, and had to let go of every employee of his company.
The shock was so painful that it robbed him of all of his arrogance.
He decided to switch his mindset from “I am right when I invest” to “how can I know that I am right”?
Ray Dalio had been collecting economic principles since he had begun working as a trader.
He decided to enter these principles into computers so he could double-check with them before making a decision.
If the computer’s predictions were different than his, he’d think twice before making a move.
The reason why using computers and not other people worked so well was that computers don’t have any biases like humans do.
It’s the alliance of human foresight with the computer’s calculating power that made Ray such a good investor.
Since Ray Dalio believes that the future resembles the past, he draws insights from the historical performances of assets that he assembles into a portfolio.
What matters most to Ray isn’t so much to have the highest yielding portfolio.
He knows he can’t predict that one asset that will outperform everything else.
No, what matters to him is to assemble a portfolio that keeps on growing no matter what happens.
As a result, he practices extreme diversification and buys stocks, bonds, currencies, metals, and even cryptocurrencies.
This is how his strategy works.
Unlike Peter Thiel or Warren Buffett, Ray didn’t think he could find the best investments.
So he focused on decreasing the risks instead of maximizing his returns.
Ray noticed that adding several assets that yield, let’s say, 10%/year with a correlation of, say, 60%, would decrease his risk.
If he added assets with a lower correlation, it would decrease the risk even more.
So his strategy was based on investing in different assets with very low correlation in order to decrease the risks as much as possible.
So he assembled different portfolios of different assets with very low correlation.
His macroeconomic view of the economy helped him see and prevent bubbles where he saw them, and his hedge fund managed to earn money almost every single year of its existence.
The modelization of the economy based on principles drawn from a historical analysis of markets enabled Ray to (mostly) accurately predict where the worldwide economy was headed.
He subsequently codified these principles in computers that over time, gave him an ever more precise picture of the economy.
This information helped him choose assets that weren’t correlated with one another and assemble an investment portfolio that “grows no matter the state of the economy”.
While Peter Thiel and Warren Buffett didn’t believe in diversification, Ray Dalio swears by it.
This shows that there isn’t only one good investment strategy to choose from, but several.
In the end, it really depends on the goals you have, the risk you’re willing to expose yourself to, and the amount of work you want to do.
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