One of our favorite investors here at The Acquirer’s Multiple is Ray Dalio, and one of the best Dalio interviews is in the book, Hedge Fund Market Wizards: How Winning Traders Win, by Jack Schwager. The book provides successful trading philosophies and strategies from fifteen traders who’ve consistently beaten the markets. In this interview Dalio talks about some of the most important lessons and experiences that he has learned from a life of investing.
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Here’s an excerpt from that interview:
Mohnish Pabrai: 6.5x Return On Deep Value Turkish Stock [2020 Letter]
As the world’s largest hedge fund, you have come quite far. I wonder what your goals were as a young man?
I played around in the markets when I was a kid. I started when I was just 12. It was like a game, and I loved the game. The fact that I could make money playing the game was good, too, but it wasn’t what motivated me. I never had any specific goals like making or managing some level of money.
It is amazing how many of the successful traders I have interviewed got started in the markets at a very young age their teens and sometimes even younger.
That makes total sense to me because the way people think is very much influenced by what they do early in their lives. Internalized learning is easiest when we are young, which is why learning to play a sport or to speak a language well is easier at an early age. The type of thinking that is necessary to succeed in the markets is entirely different from the type of thinking that is required to succeed in school. I’m sure that my being involved in the markets from an early age profoundly affected my way of thinking.
Most school education is a matter of following instructions—remember this; give it back; did you get the right answer? It teaches you that mistakes are bad instead of teaching you the importance of learning from mistakes. It doesn’t address how to deal with what you don’t know.
Anyone who has been involved in the markets knows that you can never be absolutely confident. There is never a trade that you know you are right on. If you approach trading that way, then you will always be looking at where you might be wrong. You don’t have a false confidence. You value what you don’t know.
In order for me to form an opinion about anything involves a higher threshold than if I were involved in some profession other than trading. I’m so worried that I may be wrong that I work really hard at putting my ideas out in front of other people for them to shoot down and tell me where I may be wrong. That process helps me be right. You have to be both assertive and open-minded at the same time. The markets teach you that you have to be an independent thinker. And any time you are an independent thinker, there is a reasonable chance you are going to be wrong.
Do you remember your first trade?
Yes, I bought Northeast Airlines, which flew between New York and Florida.
How did you pick that stock?
It was the only stock I had ever heard of that was also selling below $5 a share. So I could buy more shares. That was my whole analysis. It didn’t make any sense, but I got lucky. The company was about to go bankrupt, but then it was acquired, and I tripled my money. So I figured this was easy. I don’t remember anything more about any specific stocks I bought as a child. But what I do remember is that when I was about 18 years old, we had the first bear market in my experience, and I learned to go short. Then in college I got involved in trading commodities.
What attracted you to commodities?
I could trade them with low margin requirements. I figured that with low margin requirements, I could make more money.
Any early experiences in the markets stand out?
In 1971, after graduating college and before going to business school, I had a job as a clerk on the New York Stock Exchange. On August 15, Nixon took the U.S. off the gold standard, and the monetary system broke down. I remember the stock market then went up a lot, which is certainly not what I expected.
What did you learn from that experience?
I learned that currency depreciations and the printing of money are good for stocks. I also learned not to trust what policy makers say. I learned these lessons repeatedly over the years.
Any other early experiences stand out where the market behaved very differently from what you expected?
In 1982, we had worse economic conditions than we do right now. The unemployment rate was over 11 percent. It also seemed clear to me that Latin America was going to default on its debt. Since I knew that the money center banks had large amounts of their capital in Latin American debt, I assumed that a default would be terrible for the stock market. Then boom—in August, Mexico defaulted. The market responded with a big rally. In fact, that was the exact bottom of the stock market and the beginning of an 18-year bull market. That is certainly not what I would have expected to happen.
That rally occurred because the Fed eased massively. I learned not to fight the Fed unless I had very good reasons to believe that their moves wouldn’t work. The Fed and other central banks have tremendous power. In both the abandonment of the gold standard in 1971 and in the Mexico default in 1982, I learned that a crisis development that leads to central banks easing and coming to the rescue can swamp the impact of the crisis itself.
Any other events stand out as learning experiences?
Every day provides tactile learning experiences. You are asking me to describe moments. I don’t see it as moments, but rather as a string of tactile experiences. It is not so much a matter of cerebral memories as it is visceral feelings.
You can read about what happened in the market after Mexico defaulted, but that is not the same as being in the market and actually experiencing it. I particularly remember my surprises, especially the painful ones, because those are the experiences that provide learning lessons. I vividly remember being long pork bellies in my personal account in the early 1970s at a time when pork bellies were limit down every day. I didn’t know when my losses would end, and I was worried that I would be financially ruined.
In those days, we had the big commodity boards, which clicked whenever prices changed. So each morning, on the opening, I would see and hear the market click down 200 points, the daily limit, stay unchanged at that price, and know that I had lost that much more, with the amount of potential additional losses still undefined. It was a very tactile experience.
What did you learn from that experience?
It taught me the importance of risk controls because I never wanted to experience that pain again. It enhanced my fear of being wrong and taught me to make sure that no single bet, or even multiple bets, could cause me to lose more than an acceptable amount. In trading you have to be defensive and aggressive at the same time. If you are not aggressive, you are not going to make money, and if you are not defensive, you are not going to keep money. I believe that anyone who has made money in trading has had to experience horrendous pain at some point.
Trading is like working with electricity; you can get an electric shock. With that pork belly trade and other trades, I felt the electric shock and the fear that comes with it. That led to my attitude: Let me show you what I think, and please knock the hell out of it. I learned about the math of investing. [Dalio walks over to the board and draws a diagram where the horizontal axis represents the number of investments and the vertical axis the standard deviation.]
This is a chart that I teach people in the firm, which I call the Holy Grail of investing. [He then draws a curve that slopes down from left to right—that is, the greater the number of assets, the lower the standard deviation.] This chart shows how the volatility of the portfolio changes as you add assets. If you add assets that have a 0.60 correlation to the other assets, the risk will go down by about 15 percent as you add more assets, but that’s about it, even if you add a thousand assets.
If you run a long-only equity portfolio, you can diversify to a thousand stocks and it will only reduce the risk by about 15 percent, since the average stock has about a 0.60 correlation to another stock. If, however, you’re combining assets that have an average of zero correlation, then by the time you diversify to only 15 assets, you can cut the volatility by 80 percent. Therefore, by holding uncorrelated assets, I can improve my return/risk ratio by a factor of five through diversification.
What about the problem of markets becoming highly correlated? As we sit here today, if you tell me that the S&P is down 2 percent, I can tell you the direction of virtually every other market.
I don’t think that’s correct.
Really, you don’t think that’s true?
I think that’s only true because of the way you are defining markets. For example, I can’t tell you which way the Greek/Irish bond spread would move in response to the S&P being down. There are ways to structure your trades so that you can produce a whole bunch of uncorrelated bets. You have to start with your goal. My goal is that I want to trade more than 15 uncorrelated assets. You are just telling me your problem, and it’s not an insurmountable problem. I strive for approximately 100 different return streams that are roughly uncorrelated to each other. There are cross-correlations that enter into it, so the number works out to be less than 100, but it is well over 15. Correlation doesn’t exist the way most people think it exists.
What do you mean by that?
People think that a thing called correlation exists. That’s wrong. What is really happening is that each market is behaving logically based on its own determinants, and as the nature of those determinants changes, what we call correlation changes. For example, when economic growth expectations are volatile, stocks and bonds will be negatively correlated because if growth slows, it will cause both stock prices and interest rates to decline. However, in an environment where inflation expectations are volatile, stocks and bonds will be positively correlated because interest rates will go up with higher inflation, which is detrimental to both bonds and stocks. So both relationships are totally logical, even though they are exact opposites of each other. If you try to represent the stock/bond relationship with one correlation statistic, it denies the causality of the correlation.
Correlation is just the word people use to take an average of how two prices have behaved together. When I am setting up my trading bets, I am not looking at correlation; I am looking at whether the drivers are different. I am choosing 15 or more assets that behave differently for logical reasons. I may talk about the return streams in the portfolio being uncorrelated, but be aware that I’m not using the term correlation the way most people do. I am talking about the causation, not the measure.
You have had only two drawdowns worse than 12 percent in 20 years with the worst being 20 percent. How have you managed to keep your drawdowns so controlled using a directional strategy?
There are two parts to the answer. First, as we discussed earlier, we balance risk across multiple independent drivers. We avoid having too much of the portfolio concentrated in any single driver. Second, we have stress-tested our strategies through multiple time frames and multiple scenarios.
I think many people experience drawdowns that are much larger than they expected because they never really understood how their strategy would have worked in different environments. There are managers who have been in the business for five years and think, I have a great track record; this approach really works. But they really don’t have the perspective of how their strategy would have performed in different circumstances.
Strategies that are based on a manager’s recent experience will work until they inevitably don’t work. In contrast, we test our criteria to make sure that they are timeless and universal. Timeless means that we look at a strategy during all different times, and universal means that we look at how a strategy worked in all different countries. There is no reason why a strategy’s effectiveness should change in different time periods or when you go from country to country. This broad analysis through time and geography gives us a unique perspective relative to most other managers.
For example, to understand the current U.S. zero interest rate, deleveraging environment, we need to understand what happened a long time ago, such as the 1930s, and in other countries, such as Japan in the postbubble era.
Deleveragings are very different from recessions. Aside from the ongoing deleveraging, there are no other deleveragings in the U.S. post–World War II period.
Are there risk limits in terms of individual positions?
There are limits in terms of position size, but not in terms of price. We don’t use stops. We trade approximately 150 different markets, where I am using the term market to also mean spread positions, as well as individual markets. However, at any given time, we probably have only about 20 or so significant positions, which account for about 80 percent of the risk and are uncorrelated to each other.
When you are in a significant drawdown, do you do anything differently? Do you reduce your exposure?
I don’t believe in reducing exposures when you have a losing position. I want to be clear about that. The only pertinent question is whether my being in a losing position is a statistically meaningful indicator of what the subsequent price movement will be. And it is not. For that reason, I don’t alter positions because they are losing.
Is the implication that whether you are at a new high or you are down 15 percent, you will still size positions exactly the same way?
Yes, the positions taken and their size would be exactly the same.
If a position works poorly, does that cause you to reexamine your strategy?
Always. The best discoveries come from positions that don’t work out. For example, in 1994, we were long a number of bond markets, and the bond markets sold off. We have multiple rules and systems that apply to the bond markets, and at the time, they indicated a net long position for each bond market. Afterward, we realized that if we took those same systems and traded them on a spread basis rather than an absolute basis, we could produce a much better return/risk outcome. That change took advantage of the universal truth that you can enhance the return/risk ratio by reducing correlation. If there is a research insight, we change our process.
That is an example of how a losing position caused you to change your process. But what about an individual position that is losing money? I understand that you do not get out or reduce a position simply because it is losing money, but what if you change your mind because you realize that you overlooked some factor or didn’t give some factor enough weight?
No, it doesn’t work that way. The way we change our minds is a function of how that information passes through our decision rules. Our decision rules determine the position direction and size under the circumstances.
So your trading process is fully systematized rather than dependent on discretionary decisions?
It is 99 percent systematized. These systems evolve, however, as the experience we gain might prompt us to change or add rules. But we don’t make discretionary trading decisions on 99 percent of our individual positions.
What if there is some idiosyncratic event that is not incorporated in the system?
If it is something like the World Trade Center getting knocked down, then yes, we may exercise a discretionary override. In most cases, such discretion would be a matter of reducing risk exposure. I would say probably less than 1 percent of trades might be affected by discretion.
Is your process totally fundamentally driven, or does the system also include technical factors?
There are no technical inputs.
So in contrast to the majority of CTAs who use a systematic approach based only on technical factors, primarily or solely price, you also use a systematic approach, but one based on only fundamental factors.
What do you believe is the biggest mistake people make in investing?
The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment. The tendency of investors to buy after a price increase for no reasons other than the price increase itself causes prices to overshoot. When investors are making money because they’re greedy and fearless, which is typically after a large price rise, doing the opposite is a good idea.