Ray Dalio Holy Grail Explained: Ray Dalio’s success is the type of story that drives the American Dream. As a child, he and his family lived in a middle-class neighborhood on Long Island. He started working as soon as he could, collecting tips as a golf caddy when he was just 12 years old. Even then, he had an eye on the stock market, and he collected stock tips from his golfer clients along with the cash.
Dalio started investing that year, and by 1975, he was ready to enter the big leagues. He launched Bridgewater Associates from his two-bedroom apartment, and in the 40 years that followed, he grew his company to be the largest hedge fund firm in the world.
Today, Bridgewater Associates manages $160 billion in assets, and Dalio has an estimated net worth of approximately $18.7 billion.
Despite accruing wealth beyond his wildest imagination Dalio hasn’t forgotten his roots. He is active in a wide variety of philanthropic causes, with a special focus on microfinance and inner-city education. Through his foundation, Dalio Philanthropies, the billionaire works to give others an opportunity to pursue their own version of the American Dream.
How Ray Dalio Thinks About Diversification
Dalio credits much of his success to a unique method of portfolio construction – one he developed after some painful lessons about diversification during his early years of investing.
Traditional diversification focuses on protecting returns through the purchase of assets in different classes. For example, there might be a mix of stocks, bonds, and cash. Those who are comfortable with a high-risk/high-reward strategy focus on the equity side, while investors who need more stability increase their bond and cash holdings.
The problem with this method of diversification is that it can impact returns. The safer asset classes, can’t generate the sort of income that stocks do, and they don’t increase in value at the same rate.
The “Holy Grail” of investing, according to Dalio, is diversifying your portfolio in a manner that reduces risk without impacting returns.
Master Correlation, Master Investing
Though on the surface this strategy appears counter-intuitive, Dalio has made it work.
He selects assets that have little or no correlation, without sacrificing returns. Correlation refers to the rate at which assets change in value relative to each other. Positively correlated stocks increase at the same time. However, negatively correlated stocks move in opposite directions. When one increases in value, the other decreases.
The rate at which two assets move relative to each other, their correlation, is measured on a scale of (-100 percent) to 100 percent.
Two stocks that move in opposite directions at the same rate have a (-100 percent) correlation, while two stocks that move in the same direction at the same rate have a 100 percent correlation.
Stocks that have no relationship whatsoever have a correlation of zero. Their change in value is influenced by completely different variables, and they move completely independently.
Here Is An Example of Correlation
An example of strong correlation can be found by looking at stocks in the same industry.
On the other hand, healthcare stocks as a group are considered to be a smart choice, because increasing demand for healthcare services is boosting top-line revenue across the board.
Choosing negatively correlated stocks gives you some stability. When one goes up, the other goes down, protecting the overall value of your portfolio. An example is the negative correlation between oil prices and airline stocks. Because fuel is one of the biggest expenses for airline companies, a rise in oil prices can drive airline profits – and subsequently stock prices – down.
The downside to adding stability through negatively correlated stocks is losing a large portion of your upside potential.
You can prevent large losses through balancing negatively correlated assets, but you won’t realize the same returns. Dalio’s system of diversification through uncorrelated assets protects your returns while reducing your risk substantially.
Ray Dalio Holy Grail
Ray Dalio coined the concept of diversification as the “Holy Grail of Investing” in his book Principles, released in 2017. He sums up the concept this way:
With fifteen to twenty good, uncorrelated return streams, you can dramatically reduce your risks without reducing your expected returns.
He points out that most people have a mistaken understanding of diversification. They choose different assets within the same class, believing this is enough to protect their portfolios. However, as Dalio states:
Individual assets within an asset class are usually about 60% correlated with each other, so even if you think you’re diversified, you’re not.
His bottom line recommendation for building wealth is this:
Making a handful of good uncorrelated best that are balanced and leveraged well is the surest way of having a lot of upside without being exposed to unacceptable downside.
In his written and spoken workshops for investors, Dalio emphasizes the steps needed to reduce the return to risk ratio by a factor of five. In other words, you keep your level of risk the same while increasing returns five times over. This, he says, is the key to building a strong portfolio that maximizes both short-term and long-term returns.
How To Collect 15 Uncorrelated Return Streams
Building a portfolio based on this principle means collecting 15 return streams that are uncorrelated. More than that is fine, but those over the 15 mark have very little additional impact on risk reduction.
When you look at uncorrelated assets, it’s not always about the classic correlation calculation that breaks each relationship down to a percentage. Instead, it is an examination of assets and their intrinsic behavior relative to each other.
One of the issues to contend with as you work to restructure your portfolio is the fact that the correlation between stocks can and does change over time based on a variety of factors. For example, it wasn’t long ago that international stocks had a sharply negative correlation to US stocks.
However, in today’s tight-knit global economy, everyone rises and falls together. The correlation between domestic and international stocks has increased to approximately 90 percent.
What that means for you is simple. There is no such thing as building a portfolio and leaving it to grow unattended. If you want to maximize your returns and minimize your risk, you must regularly re-evaluate and reconsider your investments, making changes as needed to keep pace with changes in the marketplace.
Ray Dalio All Weather Portfolio
Dalio’s status as a self-made billionaire, and the success of his firm, Bridgewater Associates, makes him an important voice in the investing world. He offers common-sense investment strategies and methods that can be duplicated by average people when they put time and effort into thorough research.
One of the most popular concepts Dalio has developed is the All Weather Portfolio. This is a collection of investments that is carefully designed to survive unscathed through any sort of market turbulence.
According to Dalio, there are four possible “seasons” in the global economy at any given time:
- Periods of high inflation, when prices go up and purchasing power goes down
- Periods of deflation, when the prices of goods and services don’t increase as quickly as expected or decrease
- Periods of improving economic growth
- Periods of declining economic growth
Obviously, these four “seasons” are incompatible – they cannot occur simultaneously. A portfolio capable of growing regardless of “season” is a rare mix – and holds the secret to sustainable returns.
Dalio’s All Weather portfolio looks something like this:
- Long-Term Bonds – 40 percent
- Stocks – 30 percent
- Commodities – 7.5 percent
- Gold – 7.5 percent
- Intermediate-Term Bonds – 15 percent
This mix can withstand pressure no matter what is happening in the outside world.
It’s interesting to note that Dalio’s firm was one of the few that delivered returns to its investors through the 2008 – 2009 financial crisis.
Dalio had long suspected that many financial institutions were right on the edge of disaster, and he ensured that Bridgewater funds were prepared.
In 2008, while competitors were closing their doors, the value of Bridgewater’s Pure Alpha fund rose by 9.5 percent. Clearly, Dalio’s strategy works.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.