“It’s a great advantage in life to make the mistakes you learn from as early as possible.” (Winston Churchill)
The psychology of development knows the concept of existential learning. You can tell the child not to touch the hot plate. When the ceramic hob glows such a beautiful red, he might put his hand on it after all – and then learn something with every fiber of his body that the purely cognitive instruction by his parents was not able to achieve. The investor may have often heard that all knowledge about the markets always remains imperfect and limited and scattered positions are therefore elementary. If the investment story sounds so plausible and the leverage is so nice and cheap, then you will make the bet that is far too big – and then, with the tactile experience of a big loss, which can even lead to physical symptoms such as insomnia or sweating fear, you will learn that risk management is not a purely academic discipline.
Ray Dalio has had this kind of painful experience frequently and very distinctly at the beginning of his career – and learned from it. Over the years, the firm he founded, Bridgewater Associates, has become probably the largest and most successful hedge fund of all time. With around 1500 employees, it manages assets of well over 150 billion US dollars, mainly for institutional clients. Dalio condensed his learning processes into “Principles” and initially gave them to new employees as compulsory reading. As a book, he has now made the general part of these principles, together with a description of his career, available to the public. A second volume with the investment principles is to follow. An interview conducted with him in 2011 by the “industry chronicler” Jack Schwager and published in his book “Hedge Fund Market Wizards” (Wiley, 2012) already offers an important insight into this.
In the course of the disinflation phase in the USA under Federal Reserve Chairman Paul Volcker in the early 1980s, Dalio learned that it is certainly possible to correctly assess a macroeconomic situation in many aspects and yet not correctly anticipate the market reaction – for example, because important aspects were not taken into account in the assessment or because the fundamental assessment gives you little information about the timing of the market. His intensive pain experiences have made risk management the focus of his investment strategy from now on. For him, this means, on the one hand, taking precautions to ensure that Bridgewater’s assessment of future market developments is as rarely wrong as possible. On the other hand, it means ensuring that if the assessment turns out to be wrong, the company will not lose more than a manageable amount. In essence, this describes the added value that any type of asset management should be able to deliver: Anyone who actively manages assets – be it for themselves or others – should have thought about these two aspects before investing in the first euro.
Dalio’s answer to the first aspect is learning, and this requires a systematic approach that allows the investment decision to be constantly compared with the investment result. Only the feedback between action and (market) reaction allows the activation process to be improved. In a somewhat more general context, this has recently been confirmed by the study on “Superforecasting – The Art and Science of Prediction” by Philip E. Tetlock (Crown, 2015): laypersons can learn to deliver better forecasts than experts with exclusive access to certain information – if they are intellectually open and the environment gives them constant feedback so that they can adapt their processes accordingly. At a time when computers were far from being in every office and spreadsheet and charting programs were just invented, Bridgewater was already experimenting with computer-based investment control systems. They were used to systematize how changes in fundamental data were reflected in investment decisions. Using backtests using historical data – in some cases data that went far back in time and included turbulent times such as the global economic crisis – these rules could be examined and optimized in terms of the risk/return profile before they were tested live. What is now the standard tool of any quantitative-systematic investment process was then an uncharted territory, both technologically and conceptually. And since Daliu’s investment style is fundamentally motivated, these rules were not based on past asset prices as is the case with trend forecasters, but on fundamental data such as economic concepts or balance sheet information. The result was a strictly rule-oriented fundamental investment process – certainly a novelty at the time and not so common even today.
The solution to the second challenge in Dalio’s risk management considerations – not to lose too much if you get it wrong – is (of course) diversification. The “Principles” contain an analytical chart, where the standard deviation of the portfolio return is plotted on the vertical axis and the number of assets in the portfolio on the horizontal axis. The connecting function has a hyperbola-like progression, i.e. the portfolio risk falls very sharply with the transition from one to two assets, still sharply with the transition from two to three assets, but slightly less, and converges from around the sixth to the tenth asset to a low value, whereby the portfolio risk is further reduced with each additional asset, but less and less. The lower the correlation between the returns of the individual assets, the lower the value against which the portfolio risk converges.
Dalio rightly describes this correlation as the “Holy Grail” of asset management. For him, it is a guiding principle: Bridgewater should always hold a highly diversified portfolio, with the largest positions relating to at least 15 to 20 different assets. Besides, the individual positions should be as little correlated as possible. A typical equity portfolio, for example, would not be a good choice, as the correlation between the individual stocks is high at 60%, so the diversification effect is present but relatively low. A long-only investment in the DAX and long-dated German government bonds would have been much less risky over the past twenty years with a coefficient of -50% from a diversification perspective – but do you still want to be Bund long today? Dalio himself likes to invest in bonds in the form of spread strategies that play national markets against each other, without significant overall exposure to the interest rate level on the world market. Currency strategies go in the same direction. And of course, active strategies with the possibility of short positioning offer the prospect of a combination of high returns and low correlation.
With his “Principles”, Dalio transfers his insights on the management of investments to the management of employees and lifestyles. The principles of learning and (non-) correlation permeate his conception (“work principles”) of the company as “meritocracies of ideas”, organizations in which the management personnel have to earn their functions through performance, whereby performance consists of the quality of the ideas expressed. In such a form of organization, it is hoped, “uncorrelated” ideas constantly arise, which may then be examined and questioned by all and thus reach “readiness for series production”. His demands for the assumption of responsibility, for radical transparency and a permanent search for the truth, should lead to a corporate culture in which everyone contributes to uncovering each other’s mistakes and thus eliminating them as far as possible.
Whether meaningful principles of investment management are the only blessed source in the area of employee and life management is another question. Whether a person who ranks 54th on the Forbes list of the richest people in the world can credibly explain in the context of his “life principles” that money is not important in life, likewise. And whether one can take a catalogue of more than 100 certainly well-intentioned pieces of advice to heart and act accordingly without having gone through the existential learning process of the advisor, likewise. On the other hand, anyone interested in asset management can take a lot from Dalio’s life report with all its successes and failures and the insights into Bridgewater’s investment strategy.
*) The reviewer: Dr. Carsten-Patrick Meier is managing director and owner of Kiel Economics. He studied economics in Göttingen and Kiel and subsequently received his doctorate from the later Chairman of the German Council of Economic Experts, Prof. Dr. Juergen B. Donges. Between 1998 and 2008, he was head of the research group “German Economy” and later the research area “Risks in the Banking Sector” at the Kiel Institute for the World Economy. Dr. Meier is the author of numerous technical papers on the development of the economy, capital markets, and banks as well as on questions of macroeconomic modelling and forecasting.