- With 86 months of economic growth and growing money supply, the current economic environment might soon change.
- On top of the beta returns, specific alpha asset allocation can further increase your returns.
- In this article you will find a strategy that works at all times.
Ray Dalio is the most successful hedge fund manager by net gains. His Bridgewater Pure Alpha fund reached $45 billion in net gains in 2016 beating George Soros with $42.8 billion in gains since inception. What’s even more impressive is that Dalio has reached such a performance with only 4 negative years in the 40 year period.
Dalio is also famous for a simple, yet insightful video explanation that every investor should watch on how the economy works entitled “How The Economic Machine Works by Ray Dalio.”
In this article we are going to analyze his strategy and way of thinking, and see how it can be applied to an individual portfolio.
Dalio managed to achieve 36 out of 40 positive yearly returns by using the all-weather strategy. The strategy was born in 1971 when president Richard Nixon suspended the convertibility of the dollar into gold, an action that made Dalio look at markets from a broader perspective. Rather than look at the markets from a perspective of one’s lifetime, his strategy expects surprises that are beyond one’s experience.
The main question an investor has to ask themselves is “what kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?” There are a few economic environments that repeat themselves in an economic cycle and are related to economic growth and inflation, either of which can be rising or falling. The goal is to balance asset classes in a portfolio in order to minimize the effect of economic surprises.
Figure 1: Investment scenarios. Source: Bridgewater.
For such an environment Ray Dalio suggest owning inflation linked (IL) bonds like Treasury inflation protected securities (TIPS) and commodities. As the typical investor has a small percentage of his assets exposed to commodities or IL bonds, they risk to lose a significant part of their investments if inflation rises. As the money supply is constantly increasing, we are already in an inflationary environment, though the consumer price index doesn’t reflect it yet. Therefore, investors should think about allocating higher percentages of their portfolios to inflation protective assets.
Figure 2: U.S. M2 money supply. Source: FRED.
As the money in circulation continues to increase, inflation will eventually hit us but we cannot know when, therefore a 100% inflation protective strategy would be detrimental if low inflation continues. Assets that perform well in deflationary periods, as we have witnessed in the last 7 years, are equities and nominal bonds.
We have had 7 years of economic growth, but sooner or later a recession will come along. According to the National Bureau of Economic Research we have had 11 economic cycles since 1945 with the average expansion period at 59 months and the average contraction period at 11 months, so the probabilities of a recession are increasing from an economic cycle point of view. In the last two recessions stocks fell 49% (2001) and 56% (2009), so portfolios overweight in stocks are exposed to the risk of recession. In order to protect a portfolio from such a risk, Ray suggests owning nominal bonds and inflation linked bonds which always give you a return and protect you from heavy volatility.
The fourth scenario is one in which most things do well so a portfolio should also always be exposed to equities, commodities, corporate credit and emerging market credit.
In the end, a portfolio should be constructed in such a way that it does not bet on future economic situations and trends but has consistently positive returns no matter the environment.
Figure 3: All-weather portfolio allocation. Source: Bridgewater.
As one of the primary investing rules is not to lose money, the all-whether strategy is a good one to follow. Your returns will be lower in bull markets but the loses will be much smaller in bear markets.
Figure 4: Cumulative total returns and drawdowns of global equities vs all-weather portfolio. Source: Bridgewater.
The main thesis behind the all-weather portfolio is that investors are prepared for everything. A decade ago no one expected close to zero interest rates and those who expected them certainly didn’t expect they’d last for 7 years. Similarly, in 2007 the 2009 crisis seemed like something very unlikely, and the same stands for the amazing bull market we have witnessed since 2009.
The all-weather portfolio enables an investor to grasp rewards and minimize risks from all possible economic environments. As all the assets in the portfolio have betas, which means they will give positive returns in the long term, the total return of the all-weather portfolio is positive, but as assets have uncorrelated returns and behave differently in different economic environments, the downside is minimized.
In order to further increase returns, an investor can choose specific assets in the above asset risk weights. As there is a higher risk of stocks experiencing a sharp decline due to their current high valuations, more defensive stocks could be an option. Stay tuned to Investiv Daily to learn more about such investing opportunities.