Ray Dalio's Economic and Investment Principles

TLDR: 4 / 3 / 2 / 6 / 12 (see lists below)

Economic Principles 4/3/2

Four Big Forces:

Productivity
The short-term debt cycle
The long-term debt cycle
Politics

Three Important Equilibrium's:

Debt growth is in line with income growth that is required to service the debts
Economic capacity utilization is neither too high nor too low
Projected returns of equities are above the projected returns of bonds which are above the projected returns of cash by appropriate risk premiums

Two Levers:

Monetary Policy
Fiscal Policy

Six main Factors to Judge a Country’s Power By:

Innovation, meaning technology, education, and competitiveness
Economic output
Share of world trade
Military strength
Financial center strength
Reserve currency status

Economic and market movements are like a perpetual motion machine of interactions of these nine

12 Investment Principles

The theoretical value equals the present value of future cash flows
The actual value that it will trade at will equal the total amount of spending (if I calculate the total amount of dollars spent on something) divided by the quantity of goods sold
Asset classes will outperform cash over the long term
The out performance of asset classes over cash (i.e. beta cannot be very positive for too long
Assets are priced to discount future expectations. So when inflation, growth, risk premia and discount rates change, asset prices change
Every investment is a return stream
Diversification can reduce risk more than it reduces returns so it improves return-to risk ratio
Return streams can be either betas or alphas
The key to good investing is to create good portfolios of good return streams
Return streams can be risk adjusted to be risk balanced
The holy grail of investing is finding 15 or more good uncorrelated return streams
Systematize decision making; rules should be timeless and universal

Context/ DD – This is the looooong winded part

We have this broken down in terms of economic principles and investment principles because the markets follow the economy. To understand the market, you must understand the economy; to do that; you must understand the four major forces, three Important equilibrium, and two levers.
The economy and the markets are like a perpetual motion machine of the interaction of the above 4/3/2.
Over time, things get better in the quality of our personal lives. We look to increase the quality of our living, individually and as a society – This is called productivity.
Productivity is the most important thing, but we don't really see it because it evolves over a more extended period.
The big things that we see and feel every day are debt cycles. There is a long-term debt cycle and a short-term debt cycle.
By short-term debt cycle, I usually mean the business cycle.
For instance, if the economic activity rate is too low in a recession and there is weakness in the economy, the Central Banks (CBs) produce credit.
Credit is buying power. CBs produce that credit which creates purchasing power for goods, services, and financial assets – And then, the economy picks up, and that cycle typically lasts seven to ten years.
As the economy picks up, the demand rises relative to the capacity. As you get later in the cycle, the CBs hit the brakes, raise interest rates, and tighten monetary policy. The unemployment rate is low because there is less slack in the economy. They put the brakes on it by pulling the lever to increase interest rates. They tighten monetary policy, then you have a recession, slow up, which is the cycle.
And because credit is buying power, credit produces debt, and debt means the obligation to pay back.
It is crucial to understand that nature is cyclical, first comes the stimulation, then comes the paying back.
When you produce credit, you can spend more than you earn.
And when you pay back, you have to spend less than you earn.
And that is the nature of the cycle. Most of us are aware and acquainted with this cycle.
With that cycle comes market cycles. And this is all that I mean by the short-term debt cycle.
There is also a longer-term debt cycle, which is an accumulation of all those shorter-term debt cycles.
Because everybody wants things to go up, they want their asset prices, the markets, and employment to go up.
For that reason, CBs will stimulate the economy, typically lowering interest rates until interest rates hit zero.
When interest rates hit zero, they can't do that anymore, which brings us to the need to print money and buy financial assets, which we call quantitative easing (QE). And when CBs can't do QE anymore, or there are limitations imposed, we come to the end of the long-term debt cycle.
So now we have covered a short-term debt cycle, a long-term debt cycle, and productivity.
Now, related to all of that is politics. There are Internal politics and external politics. And in that normal cycle, they are related.
For example, in 2008 and 2009, there was a debt cycle, and interest rates hit zero. And that is very similar to 1929 to 1932. There was a debt crisis, and interest rates hit zero.
And in both of those cases, there was a printing of money and buying of financial assets. And this caused those financial asset prices to go up and more economic liquidity. And that particularly benefited those with financial assets and contributed to the wealth and income gap, as did technology.
As a result of that, in the 1930s and also now, politics entered the picture, and the wealth gap is causing populism. A populism of the left and populism of the right has an effect on the markets and an impact on the economy.
So we are seeing a situation very similar to the 1930s in which we are seeing a rising power challenging an existing power, which is a geopolitical cycle.
When a rising power in the form of China is challenging an existing power in the form of the United States, and if we look at the history and cycles of those periods – There is a cycle of conflict and peace.
Typically, peace happens after war because some dominant country wins the war, and nobody wants to fight the dominant power, which creates an extended period of peace.
And I am not saying we will have a military conflict, although that always exists as a possibility.
These cycles have happened over and over again.
Politics can affect the cycles. For example, the shift in the United States to create a tax cut helps the corporate tax picture and causes stock prices to rise.
Okay, those are all the cycles. Then, we compare it to three equilibriums.
First, debt growth must be in line with the income growth required to service the debt.
If debt growth is faster than the income growth that will service the debt, we will have an adjustment, and I am always doing a Pro-forma. What is the ability to service that debt? This is the first equilibrium.
The second equilibrium is that the economic activity or capacity utilization rate is neither too high nor too low. That means, if you have it pressing up too much or overheating the economy, that will cause a tightening monetary policy and a correction.
If you have it too low so that the economy is depressed, and there’s a lot of slack, that's going to cause an adjustment to bring it up, so always be watching where we are relative to that because that is a key driver of the cycles.
The third equilibrium is that the projected returns of equities are above the projected returns of bonds above the projected returns of cash by appropriate risk premiums.
In other words, the capital markets produce the circulation of buying power in the form of this credit, and this relationship of the cash to bond yields to stock yields and asset classes determines how money flows through the economy.
And for normal condition (for reasons I won't digress into) is to have cash have a lower return than bonds that have a lower return from equities, having to do with how the system works.
CBs put cash on deposit, and people with better ideas have to make a profit to use that money to create these other levels of economic activity and have higher returns.
When that is not the case, the way they tighten it is through the use of two levers.
The two levers are monetary policy and fiscal policy.
Monetary policy is how the brakes and gas are put on, and the brakes and the gas being put on become reflected in each of these other items.
If debt growth is too high relative to income growth and capacity utilization is high or stretched, CBs will tighten monetary policy.
The tightening of monetary policy will change the projected return of cash relative to bonds and those equities, and those risk premiums will slow the economy down.
And that will drive those cycles, and that's how the economy operates in this perpetual motion.
If you could picture where you are in those cycles and what is happening, you can anticipate what will happen next because it is that perpetual motion machine.
That is the template in a nutshell. You must constantly be thinking, where are we now?
Here is some hard data for you:
When you look at GDP going back to 1900, and again GDP is productivity, there is a significant inevitable force that happens over a period of time. Even the most significant economic turbulence you know, looks like a bump in that cycle. Productivity is a big force; betting on productivity is a big force.
As you get later in the long-term debt cycle, what happens is that productivity begins to slow because there needs to be an investment, and there needs to be other things. When there is activity or prosperity, you get more productivity, a self-reinforcing cycle.
Suppose you examine charts showing productivity over a certain period in developed countries and China. In that case, you will see in varying degrees that productivity will bend over as they are later in their longer-term cycle—US, China, Japan, etc.
Japan is later in that debt cycle, and you see hardly any productivity growth.
That is what productivity looks like- Now, where are we in the short-term debt cycle of the business cycle?
See Appendix A & B to see what the cycle looks like
What happens from the capital markets (stock market) perspective – as you begin to go to higher levels of operating rate and lower levels of unemployment, CBs begin to tighten, liquidity starts to tighten, and risk premiums begin to rise.
As of March of 2019, we were nine years into the cycle, unemployment rates are comparatively low, and there is less slack, so it is no surprise that CB tightens monetary policy.
The CB tightens monetary policy by either raising interest rates or lowering the purchases of the financial assets they buy by expanding the balance sheet. And that is where we were as of q1 2019.
If you look at how markets behave in that part of the cycle, we break cycles into three pieces. The early phase of the cycle, the mid phase of the cycle, and the late phase of the cycle
Typically when you are late in the cycle, it coincides with less attractive returns.
Interest rates hit their lows and can’t go lower, so we deal with quantitative easing.
If you look at a chart going back to 1900 and examine the debt to GDP ratio to examine how now, it seems like the cycle we went through in the 1930s.
In other words, because of the debt crisis and interest rates hitting zero, you had the printing of money, as evidenced by examining the CB balance sheet, the monetary base, and the acceleration of printing money. The same thing happened in the 2008 financial crisis. You can see the debt crisis; you hit zero in interest rates, they are stuck, so they have to print the money, and then we have the reaction.
Very similar to 1932 to 1937, as the economy picked up, in 1937, they started to tighten monetary policy because they were worried the economy was overheating and inflation was going to rise, and they caused a recession.
That was the first time they used the word recession. It was like re-depression, and they used the term recession, which was the 1938 period.
We talked about debt, but there are also unfunded liabilities that we don’t call debt – which would be pension and health care liabilities. There are a lot of liabilities/promises out there that must be kept.
As it relates to both the markets and the economy – we have been in a Golden age of capitalism in the following sense – Profit margins have more than doubled since 2000, meaning that if you didn't have an expansion in profit margin – the stock market would be 40% lower.
Profit margins grew because of several factors such as efficiencies gained with technology, globalization creating a larger market share, and companies reducing union membership, which reduced employee compensation and contributed to the growth of the wealth gap.
The wealth gap or profit gap has been great for companies, but it has not been great for a certain percentage of the population. If you look at the conditions of the bottom 60% percent of the population, and the bottom 60 means the majority, the conditions have been bad.
Since 1980 there has been no real income growth in the United States. In a Fed survey, 40% of all Americans could not raise $400 in the event of an emergency. So there is a gap.
The wealth gap is seen by looking at the net worth of the top 1/10th of 1% of the population's net worth, which is almost the same as the bottom 90% combined.
As a result, we have populism, populism on the left, and populism on the right. That is a phenomenon that developed countries didn't use to have. Not only is it a political phenomenon but an economic and market phenomenon.
Because as we go into the political elections in countries such as the US and throughout Europe, it will be a conflict of capitalism over socialism or the left and the right, and it will become extreme in both cases.
And as these profit margins improved and corporate tax rates have gone down, you also have cheap money used to buy back stock or make mergers which also helps boost stock prices.
Many of these items will not continue. In Q1 of 2019, this model predicted that profit margins would go down, and you were at the best of the corporate tax rates, so that likely won't go much lower.
This all means that we are entering a new environment that will not be as conducive to purchasing financial assets by the CB. Simply put, we are going from tailwinds to headwinds.
To give you a flavor of what this political situation is like and the polarity and the entrenchedness – you can look at charts going back to 1900, which show how conservative the republicans are through a survey to examine economically conservative. And as of 2019 – they are more conservative than ever.
You can look at another chart back to 1900 examining how liberal democrats are in policy, and they are also more liberal than ever.
This means both parties have not had greater polarity than we have today.
Suppose you include the votes cast along party lines in each chart. In other words, republicans are sticking with republicans, and democrats are sticking with democrats. In that case, it easily depicts the entrenched conflict we are having in the US.
The political polarity is not just taking place in the US but also in Europe. It was expected that Jeremy Corbyn would remain in power in the UK, which would impact capital flows.
But France elected Macron, and the UK elected Boris Johnson. Boris is center-right, and Macron is socially and economically left.
So we are relatively late in the cycle and entering a period where CBs have less power than they used to ease in conjunction with populism in election cycles.
You can judge the capacity of a country to ease by looking at the level of interest rates relative to zero, the amount of quantitative easing that can take place, and its marginal effects.
For example, in the US – you go from 2.5% to zero, then you are done.
But in Europe, there are limitations, caps at 33% of certain types of debt that they can’t go beyond unless there is some type of agreement politically, which is very difficult to agree on anything. So there is going to be a problem for the European Central Bank ECB to have the ability to stimulate.
Japan was somewhat similar when they had slightly negative interest rates, reducing the ability to stimulate.
So that is the lay of the land with markets and the economy with the 4/3/2.
Moving on to the rising power challenging the existing power – China will be an important influence in the world we are operating in for the rest of our lifetimes. And China will become an increasing influence in globalization and so on.
When you examine the relative output of China and the US and what is likely in terms of equity market cap and share of debt securities outstanding, you will see the strength of these powers.
In other words, the Chinese/Asian markets are becoming more prominent, liquid, and effective. These markets will play an important role, as will the Chinese economy in our environment, not only in the form of trade but also in the form of geopolitical impacts, mainly reflected in technology.
If you look at history and what caused countries to succeed and fail, it was mainly driven by technology.
When you examine the rise and decline of world reserve currencies, first, to do that, you first have to examine the arc of each of these currencies.
There is the US dollar; before that, you had the British pound, and before that, you had the Dutch Guilder. And as a result of that, you need to understand several things about the economies that made them a reserve currency in the first place. How did they become reserve currencies, and how did they lose their reserve currency status? This means we must watch several factors, statistics, numbers, and indices.
So we get down to the six main factors you can judge a country's power by:
innovation, meaning technology, education, and competitiveness
Economic output
Share of world trade
Military strength
Financial center strength
Reserve currency status
Power is a vague thing, and you can have economic power, you can have military power, and you can have power in different ways.
We will examine these factors over four cases, the Dutch cycle, the British cycle, the US cycle, and the Chinese cycle.
In examining these cycles, the first is innovation, meaning technology, education, and competitiveness. Mostly a new technology, like the 5G technology, and the issues pertained to Huawei and other technology companies.
If you have the technology, it works both economically and militarily. And in the case of the Dutch, it was the ability to build ships that could go anywhere worldwide. And they took those ships, and because the Europeans were experts in fighting, they always fought with each other – They took the guns, put them on the boats, went out to the rest of the world, and accounted for half of the world trade.
And when they go out there with half of the world trade, they bring their money, the Dutch Guilder, and when they bring the money, it becomes a world reserve currency.
To go out into the world, they must have a military to support that.
And so these cycles go on, and if you were to look at a chart to exemplify this with the US being blue and China as red, going back to 1500 and averaging these things, what you would see is the Chinese have typically been number one or number two.
Although the world was a different size, those were all very far away places, compared to the way we live now, where it is all one sort of world.
And this will conclude the economic principles; as of 2017, we were relatively late in the business cycle, metaphorically the 7th inning.
There is a relative tightening of the business policy and monetary policy; we have less economic capacity, greater polarity, and a situation where we will have political issues, and those political issues will be market issues.
Because as we start to think – will this be a movement to the right or the left – that will impact capital flows.
Now we will transition to the list of Investment principles (Appendix C)
First is #1. – The theoretical value equals the present value of future cash flows.
In other words, every investment is a lump sum payment for a future cash flow.
So when we think about what is something worth, we look at those projected cash flows, and we discount them with an interest rate to arrive at the theoretical value.
The actual value that it will trade is listed in Investment Principle #2
2. – The actual value that it will trade at will equal the total amount of spending (if I calculate the total amount of dollars spent on something) divided by the quantity of goods sold.
So we should always be looking at how much will be spent, what are the spenders' motivations and determine the quantity.
In short, we estimate the total spending divided by the quantity to estimate the price.
And #3. – Asset classes will outperform cash over the long term.
This is required; otherwise, the economy's gears come to a screeching halt.
And #4. – The out performance of asset classes over cash (i.e., beta) cannot be very positive for too long.
Because if it were, it would be easy; if it were positive, you would borrow cash, buy the long things and make a lot of money.
It comes with big bumps along the way.
This brings us to #5. – Assets are priced to discount future expectations. So when inflation, growth, risk premiums, and discount rates.
And #6. – Every investment is a return stream.
What I mean by that is every day, you can mark it to the market, and you know what it’s like, so the key is to put together portfolios of return streams so that they balance well.
Dalio says that whatever success he has or Bridgewater has experienced has to do with knowing how to deal with their not knowing more than anything they know. This is because what you don’t know is a lot, and you can reduce your risk a lot more than you will reduce your return by knowing how to diversify well.
This is Investment principle #7. – Diversification can reduce risk more than it reduces returns, so it improves return-to risk ratio
And then, we need to get to the next one, which deals with understanding that there are two types of return streams #8. Return streams can be either betas or alpha.
What I mean by a beta return stream is that there is an intrinsic reason that that asset class will behave in a certain way that you will know.
In other words, if growth rises faster than discounted and interest rates don’t rise much, you know that stocks will go up.
So there is an environmental so you can structure that.
Alpha is a zero-sum game; in other words, for me to produce alpha, I have to outperform and take money away from somebody else. This is zero-sum, like a game of poker.
And again, #9. – The key to good investing is to create good portfolios of good return streams.
And to balance them, you have to risk balance them, which is #10. – Return streams can be risk-adjusted to be risk balanced.
In other words, somebody might think that if I put 50% of my dollars in stocks and 50% of my dollars in bonds, I am diversified, but that is not true because the volatility of stocks is twice the volatility of bonds. And because of that, you have to risk balance them.
And then #11. – The holy grail of investing is finding 15 or more good uncorrelated return streams
And lastly, systematizing decision rules is critical – #12. – Systematize decision-making; rules should be timeless and universal.
What I mean by that is – we should write down the criteria for investing, and then we take those criteria and test them through all periods of time and all countries, timeless and universal.
Because if something happened at one time and your process is not working at that time, then it must be that you haven’t explained the differences.
And so, by forcing ourselves to try to make those rules timeless and universal, it becomes the standard that we operate by. So all rules that you operate by should be timeless and universal.
35:31
If we were to pass through some charts, for example going back to 1975, and you would think of this chart as the “rolling returns of asset classes,” you would be able to see that all asset classes have good times and times that are bad.
And on average, they are above zero, but they all have down periods.
And inevitably, what happens is that most investors love the asset classes that did well. The biggest mistake of most investors is that they think the investment that did well is a good investment rather than thinking of it as a more expensive investment.
So you can break the drivers of asset class returns into a few categories, which is true for all asset classes – two main things drive it: inflation and growth.
***Basically, if you tell me that inflation is going to be higher than expected and growth be higher than expected, then I would know what to invest in, ***higher than discounted. Not sure if he messed up on 37:08 when he said “higher than expected and higher than discounted.”
But if we knew that, we would all know what to invest in.
So those become the two main drivers; they can rise or decline.
And then, there are discount rates and risk premiums (sometimes written as risk premia).
Discount rates mean the interest rate impacts all asset classes because the interest rate is the discount rate you use to compare the cash flows.
*So if you raise the interest rate that is negative for all asset classes, and then you have, when you strip all that risk premium out, that equals the following.
A chart that shows what happened in history in relation to that context.
As an example, a chart would show growth assets relative to assets that you would hold if you had a falling growth environment and assets that you would hold if you had a rising growth environment and the same with inflation, and then add what the discount rate is and then also looking at the risk premium which would be the residual of that, and that's what we have an all-weather return. An all-weather return is an optimally diversified portfolio.
And if you were to examine the data on diversification, you would see that diversification can substantially improve your risk-to-return ratio.
Turning to a chart that would show the holy grail of investing.
The X-axis shows the “number of assets/alphas in the portfolio” from 1-20, and Y-axis shows the “annual portfolio standard deviation.”
And if you can do what this chart depicts, you will make a fortune and be very successful, and it is simple but not easy.
The concept is that if you can get 5,10,15,20 good uncorrelated investments, you can substantially improve the return to risk ratio.
The chart illustrates that diversification is more important than good, even in picking the best investments.
Most people think, give me the best investment and let me put all my money in what I think is the best investment, but that is wrong.
The goal is to find your best ten uncorrelated investments and put your money in that, and you will do a lot better.
So again, if you look at that chart, and the y-axis, the standard deviation, let's call that risk, of 10%, and imagine, I invest in an asset that has 10% return and 10% standard deviation and let's say I put in a second investment that is 60% correlated with that, third, fourth, fifth, sixth, and so on, you can see how the risk in your portfolio would significantly be reduced.
This means if you have a diversified portfolio of stocks. FYI the average stock is about 60% correlated with average other stocks. You can put in 100 investments; you can put in 1,000 investments – you are not going to materially reduce your risk relative to just putting in 5 – 10, which will reduce your risk by 10 to 15% if you have an uncorrelated return stream. You can get actually get better than uncorrelated because you can have negatively correlated, but let's say I put in an uncorrelated return stream; you would see what the chart would show. For example, you more than cut your risk in half at five uncorrelated return streams. If you go to 15 uncorrelated return streams, you will reduce your risk by nearly 80%.
This means you have improved your return to risk ratio by a factor of 5.
To recap, you can reduce your risk significantly without reducing your return, which is the key to it.
So when I look at this, I think there are two types of assets; what's your strategic asset allocation mix? What is your beta? In other words, what portfolio do you usually have? In my opinion, it should be highly diversified, but along those lines in terms of something like half in growth, half in inflation rising and declining. Then alphas, you have to have a lot of different alpha. In the case of Bridgewater, there are over 100 different types of alphas and about 130 different kinds of markets in terms of trading.
Appendix A: Coming soon – Reach out if you would like to assist
Appendix B: Coming soon Reach out if you would like to assist
Appendix C: (Same list from beginning of post)

TLDR: 4 / 3 / 2 / 6 / 12

Economic Principles 4/3/2

Four Big Forces:

Productivity
The short-term debt cycle
The long-term debt cycle
Politics

Three Important Equilibrium's:

Debt growth is in line with income growth that is required to service the debts
Economic capacity utilization is neither too high nor too low
Projected returns of equities are above the projected returns of bonds which are above the projected returns of cash by appropriate risk premiums

Two Levers:

Monetary Policy
Fiscal Policy

Six main Factors to Judge a Country’s Power By:

Innovation, meaning technology, education, and competitiveness
Economic output
Share of world trade
Military strength
Financial center strength
Reserve currency status

Economic and market movements are like a perpetual motion machine of interactions of these nine

Twelve Investment Principles

The theoretical value equals the present value of future cash flows

2. The actual value that it will trade at will equal the total amount of spending (if I calculate the total amount of dollars spent on something) divided by the quantity of goods sold
3. Asset classes will outperform cash over the long term
4. The out performance of asset classes over cash (i.e. beta cannot be very positive for too long
5. Assets are priced to discount future expectations. So when inflation, growth, risk premiums and discount rates
6. Every investment is a return stream
7. Diversification can reduce risk more than it reduces returns so it improves return-to risk ratio
8. Return streams can be either betas or alphas
9. The key to good investing is to create good portfolios of good return streams
10. Return streams can be risk adjusted to be risk balanced
11. The holy grail of investing is finding 15 or more good uncorrelated return streams
12. Systematize decision making; rules should be timeless and universal

Ray Dalio’s Economic and Investment Principles

Comments

Leave a Reply Cancel reply