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By Samuel Lee

A version of this article was published in the December 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.

I try to learn from the best. Ray Dalio is one of them. He founded Bridgewater Associates, one of the biggest hedge funds in the world. Many retail investors have not heard of him, probably because his funds are open only to big institutions. It's a terrible mistake to limit yourself to listening only to the musings of mutual fund managers. Doing so means that you will ignore many of the best investors.

Dalio's perspective is invaluable. He's willing to entertain seemingly loony ideas. For example, in 2001 he had his firm develop a depression gauge. In 2003, Nobel Prize-winning economist Robert Lucas declared that the "central problem of depression prevention has been solved, for all practical purposes, and has in fact been solved for many decades." Five years later, in late 2008, Dalio's depression gauge went off. Bridgewater was one of the few firms that anticipated and successfully navigated the financial crisis and its aftermath. Unlike many other money managers, Bridgewater predicted low interest rates and low inflation even after the Federal Reserve and other central banks worldwide embarked on rounds of massive and unconventional monetary stimulus.

A great deal of Dalio's success owes to his admirable willingness to admit error and self-correct. He expects the same of his workers. He says, "At Bridgewater people have to value getting at truth so badly that they are willing to humiliate themselves to get it."

In many respects, Dalio is the anti-Warren Buffett. Buffett makes big bets on a handful of companies. Dalio makes many small bets on currency pairs, commodities, bonds, and, to a much lesser extent, equities. Buffett grants his subordinates plenty of autonomy and lets them figure out their own way. Dalio imposes a set of principles that his subordinates are to live by and heavily monitors them. Buffett doesn't give much thought to economic cycles. Dalio's investing style is based on identifying and navigating them. Buffett doesn't like gold. Dalio thinks everyone should own a little bit of it.

Because Dalio's found success in such an unconventional way, his methods are a rich vein to mine for lessons. After all, successful investing requires delinking your perspective from the consensus. Here are some of the most important lessons I learned from Dalio and his colleagues at Bridgewater.

The long- and short-term debt cycles are the biggest reasons the economy deviates from trend-line growth.
According to Dalio, the economy's behavior can be largely explained by three forces: trend productivity growth, the long-term debt cycle, and the short-term debt cycle. Productivity growth occurs due to technological progress and is the most important force over century-long scales. Exhibit 1 is a chart reproduced from Dalio's paper, "How the Economic Machine Works." It shows trend growth of per-capita income has been steady, especially after World War II.

Over, say, five to seven years, the short-term debt cycle dominates. It occurs when the central bank tightens and loosens credit. It's also known as the business cycle. When credit and money grow faster than real economic production, inflation rises, spurring the central bank to raise interest rates and tighten credit, leading to a recession. When inflation is under control, the central bank lowers interest rates and loosens credit to spur economic growth. Many investors focus on where they are in the short-term cycle.

So far, Dalio's model is conventional. His key insight is observing that there's a long-term debt cycle, which operates over decades. During the leveraging phase of the cycle, debts rise faster than incomes in a self-perpetuating manner. Households and firms borrow money, which they spend. Because someone's spending is another's income, overall spending-the economy-grows. Asset prices go up. With greater incomes and more valuable assets, firms and households borrow even more and lenders are eager to lend. And the cycle continues. Part of the growth in incomes and asset prices during this phase is illusory; rising leverage has the effect of pulling forward wealth from the future.

While the process can go on for a long time, debts cannot rise faster than income forever. The process hits a wall when the central bank can no longer stimulate the economy because the short-term interest rate required to restore full employment is below zero.

According to Dalio, deleveragings are achieved through four channels: 1) debt write-downs; 2) the transfer of wealth from the haves to the have-nots; 3) austerity; and 4) money printing. The first three channels are deflationary. Money printing is inflationary.

How a deleveraging evolves depends on the relative contributions of deflationary and inflationary forces. Because deleveragings occur once a lifetime, policymakers don't know how to manage them. Guided by conventional wisdom, they usually turn to austerity and debt restructurings to bring down debt levels. The result is an "ugly" deleveraging, during which the economic pain is worsened and the debt/income ratio actually rises because incomes fall faster than debts. Policymakers see that their medicine isn't working and turn to fiscal stimulus and money printing to ease the burden. This is what occurred in the U.S. in the 1930s and in Europe in the aftermath of the financial crisis.

If authorities balance deflationary interventions with the right amount of money printing, the deleveraging enters a "beautiful" phase. The pain of debt write-downs is spread out. Growth is subdued, as the economy must rely on productivity improvements to grow. The United States is undergoing the most beautiful deleveraging in history, according to Bridgewater. This puts Bridgewater in an unusual camp. Of Ben Bernanke and America's central bankers, Bridgewater co-president David McCormick has said, "History will look back on them as having responded in a way that was both necessary and heroic."

Deleveragings take decades to work themselves out. According to this model, we've still a long way to go before short-term interest rates rise.

Study distant times and distant places to understand what's going on today and how events will probably transpire in the future.
Many investors were caught flat-footed by the financial crisis and the way assets behaved in its after-math. They assumed the ghost of the Great Depression or post-bubble Japan would never visit the U.S.

Dalio, on the other hand, studied the great inflation of Weimar Germany, the Great Depression in the U.S., Latin America in the 1980s, post-1990 Japan, and other economic disasters. He seriously considered whether such events could transpire again and what caused them.

Conventional economists and investors on Wall Street focus on post-World War II data for several reasons. First, many believe old data is misleading because the economy has changed so much. Second, many data sets begin only in the 1960s or 1970s. Finally, the possibility of extreme outcomes implied by the historical record and foreign experience is frightening and easy to rationalize as irrelevant.

There's no such thing as correlation.
Many investors diversify their portfolios based on historical correlations between asset classes. Bridgewater argues that correlation is not a real thing. It is a statistical artifact of the idiosyncratic economic shocks that affected the assets examined in the past.

It makes perfect sense. Different asset classes react in rational, fairly predictable ways to different economic conditions. Assuming a historical correlation will hold going forward is a bet that future economic conditions will, on average, look like the past. This is rarely true, which is why correlations are fairly unpredictable.

Exhibit 3 shows the rolling five-year correlation of the monthly returns of the S&P 500 and the Ibbotson Associates Intermediate Treasury Bond Index. The sign doesn't switch randomly. There seem to be long-lived regimes.

According to Dalio, stocks and bonds are both positively correlated when inflation expectations are more volatile than growth expectations, and negatively correlated when they're not. This makes sense, as inflation uncertainty strongly affects the market's discount rate. When discount rates rise, both stocks and bonds are hurt, and vice versa.

Bridgewater calls this type of analysis the "structural" approach to correlation. Based on it, Dalio invented the now-famous "risk parity" strategy, which attempts to balance a portfolio's exposures to rising growth, falling growth, rising inflation, and falling inflation such that it's not severely hurt when the economic environment changes.

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Source: What I Learned From Ray Dalio