At the Bloomberg Markets 50 Summit on Thursday, Ray Dalio spoke about his trading strategy for the first time ever (we think) in public.
It’s actually quite simple. He’s found that 15 uncorrelated return streams is the perfect number – any more than that and you only reduce your risk by a small percentage. But at 15, you reduce your risk by about 80%.
How you choose those 15 depends on your view of gold, for example. However you can take no view. Your concentration will be determined by that.
If you have 15 or more good, uncorrelated return streams — the maths of that is such that if you go from 1 to 2 uncorrelated return streams. That you will reduce your risk by about 80% at about 15. And there’s a certain maths to it; there’s a certain structure to it. If I was to show you a chart, I could describe it mathematically. So for example, if I had return streams that were 60% correlated, and I had a thousand of them, I would only reduce the risk by about 15%. And after 5 or 6, it’s limited. SO there’s a certain notion when approaching investing. What do I want? I need to have a certain structure. That can come in the form of alphas and betas. What is my risk neutral position? I’ll say everybody in the room, they say what should I invest in? They don’t start off, I think, with what is a neutral position. What represents a good neutral position, balance? For example, does gold represent a part of my portfolio? What should, if I had no view, what should the concentration in dollars be? What is a structural beta portfolio? And then how do I take a deviation from that beta portfolio? And how do I do that in an uncorrelated way, so that I can then maximise my return to risk? So in that first principle, what I’m saying is that if you follow that first principle and you get 15 good — don’t have to be great — uncorrelated return streams, you’ll improve your return to your risk by a factor of 5. That means 5 times the return for the same amount of risk. That’s just a principle; that’s a reality…
When I say uncorrelated asset classes, what I’m really doing is not using the classic measure of correlation, like stocks and bonds are 40% correlated. What I am instead really referring to us, do you know how they behave, and is it intrinsically going to behave alike or differently?
Dalio also said some interesting things about what he assumes will happen during the daily “exchange.”
Every day there is an exchange. And if you look at all the reasons for that exchange, there are some reasons that — some are allowed to own this. Or let’s say banks buying. Banks, when they buy bonds, have limitations. So because they bought a certain amount of bonds over a period of time when they could expand their balance sheet, does not mean that they continue to do that. Because they can’t expand their balance sheet. So therefore you could not have that same amount of buying, and that’s that number up to the amount of selling that needs to happen. Is there a gap? It was apparent, I think. Should be apparent, if you do the numbers, that there would be a gap. How big is the gap? Who is going to fill the gap?
And here’s what Dalio said about what will happen next. There are three main choices, and then there’s the varied combinations of those so that the actual options are really exponential, but limited to a point. In short they rely on the basis that Europe cannot print more debt. Countries like China have to print more debt. And the U.S. can, but only up to a point, print more debt.
The choices are you can either (1) transfer wealth from the rich to the poor, or you can (2) print a certain amount of money, or you can (3) write down the debt. And you can go through and you can figure out which of those you want to do and that’s one more choice… You just have to go through a list of sovereign restructurings… You can’t make the old party that everybody’s going to borrow a lot of money and have a party. Those days are g-, you can’t do that again. You can’t contine, you run out. So a deleveraging in a very simple sense is… Credit is a promise to deliver money. It will produce GDP but you’ll create credit… So you reach a certain point that that you can’t do that anymore… There are choices. And how to we best support, apportion the money? How much is going to be transferred? So you know, there’s a certain amount through the ESFS; there’s that number. Just do that numbers. Then how much of it is going to be essentially money creation, or let’s say, the expansion of the balance sheet (the private credit by the ECV)? Or, how much of it is going to be restructuring? Let’s get those numbers right; let’s look at it, make sure it’s orderly. That is a better path I think than the path we are on now, which is, like, every day is a big surprise.”
But here’s probably the most genius thing he said all morning:
The main reason I write the daily observations is because I want to know where I’m wrong. So lots of times if somebody points something out it helps me, and I want to have a diversified bet of uncorrelated bets.
So every day, he gets feedback and criticism from a wide range of investors.
Here’s a full transcript of his interview with Bloomberg’s Erik Schatzker, thanks to transcribing done by the Greenwich-based investment fund Thoughtful Capital Group:
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