- Ray Dalio — the founder and cochief investment officer of Bridgewater Associates, the world’s largest hedge fund — thinks "diversifying well is the most important thing you need to do in order to invest well."
- He develops his thesis around a focus on the unknown and the return-to-risk ratio.
- Dalio provides 10 eye-opening charts that show the power of diversification compared to an array of other assets and sectors.
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Chances are you’ve heard the old "don’t put all your eggs in one basket" adage a few hundred times by now.
But when a self-made billionaire investor offers an unsolicited take on the matter, it’s best that a market participant leans in with intention.
"Diversifying well is the most important thing you need to do in order to invest well," Dalio stated in a recent LinkedIn post, echoing one of his most fundamental investment principles.
He backs up his thesis with two main arguments: (1) the unknown is much greater than the known, and (2) diversification can boost your return-to-risk ratio more than anything else.
First, let’s tackle the unknown.
"Just as it’s pretty easy to pick good horses that will likely outperform bad ones at the racetrack, it’s pretty easy to pick good companies that will likely do better than poor ones in a market," he stated. "The hard part is converting this knowledge into winning bets because of how the payoffs reflect what is known."
This is an interesting analogy, but one that is definitely apropos.
The stock market is a discounting mechanism. That means that all available information, both present and future, is incorporated into it’s value. It rapidly adjusts to changing circumstances, just like the betting at a racetrack. The market is discounting and pricing in different unknowns perpetually.
Dalio sums up this idea perfectly:
"All investments compete with each other, a lot of smart investors are trying to pick the winners (which changes the pricing that determines what you will win relative to what you will lose in various outcomes) and the uncertainties of what will transpire are large relative to what is ‘discounted’ or ‘priced in," he stated.
Dalio added: "This means that there are no easy good or bad bets in the markets, and that one’s starting point should be that all investments are roughly equally good."
In short, the unknowns that are currently "priced in" are most likely going to be much different than what actually transpires.
Next, the return-to-risk ratio.
"Diversification can improve your expected return-risk ratio by more than anything else you can do," he stated. "Diversifying well is a matter of knowing how to reduce your expected risk by more than you reduce your expected return."
The return-to-risk ratio aims to quantify the amount of pain an investor can endure for potential gains. For context, a simple demonstration would be an investor that’s willing to lose 10% in order to gain 30%, which equates to a return-to-risk ratio of 3. A result less than 1 means you’re willing to risk more than you’re forecasted to gain — not a smart idea.
However, it’s impossible to accurately predict the future performance of an asset over time. It doesn’t matter how many models, regressions, or ratios you run. This notion is not feasible. That’s why Dalio wants you to reduce your risk diversifying.
"While you can’t know which of the items you are betting on will provide better results, you do know that they will behave differently, and by mixing them appropriately you can reduce risk."
Simply put, Dalio wants you to stack the deck in your favor. Investing is all about probabilities.
Spreading bets (responsibly) throughout the market helps to smooth out performance, and lessen the impacts of wild swings. Lessened risk translates into an improved ratio, and if you can avoid large losses, you won’t consistently be fighting an uphill battle.
Against that backdrop, Dalio provides 10 charts that depict exactly why diversification is the most important thing investors need to do.
Diversification across US & global asset classes
US & Global Asset Classes/Dalio
These graphs incorporate US equities, US bonds, US credit, US IL bonds, global IL bonds, global bonds, global DM equities, global EM equities, and gold.
In the leftmost graph, the dark black line shows an equal weighted (re-balanced monthly) portfolio’s performance versus that of individual asset classes. The black line portfolio trounces the majority of individual asset classes, and participates in less of the pain.
In the graph on the right, it’s clear that a well diversified portfolio mitigated drawdowns, and was able to outperform the individual asset classes.
There’s no magic here. Just math.
Diversification across countries
These graphs include stocks from the US, Great Britain, Germany, France, Spain, Italy, Japan, Canada, Australia, and China.
In the graph on the left, the same holds true for the rolling 10-year ratio for different countries. Higher ratios, and less pain felt during hard times.
On the right, drawdowns are far less severe. Remember, large losses are not offset by large gains. A 50% loss, requires a 100% gain to get back to even.
Diversification across bonds
These graphs include bonds from the US, Great Britain, Germany, France, Spain, Italy, Japan, Canada, Australia, and China.
We continue to see the same narrative play out in the leftmost graph.
On the right, a well-diversified bond portfolio overtly suppresses drawdowns. This graph depicts just how risky individual bond holdings can be. Idiosyncratic risk can upend returns.
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