What Ray Dalio's Strategies May Teach Us About Long-Term Investing

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Includes: DIA, IWM, QQQ, SPY
by: D.M. Martins Research

Summary

Bridgewater's Ray Dalio has laid out the exact asset class allocation that an unsophisticated investor can replicate to achieve results that are similar to those of Bridgewater’s All Weather fund.

Back-testing indicates that the “All Seasons” portfolio may be a superior investment strategy to most others available to the average investor.

The All Seasons portfolio, despite its simplicity, challenges a few traditional views on long-term investment strategies, and has taught me a couple of (perhaps surprising) lessons.

Perhaps the best book about personal finance that I have read this year, to my surprise, was not written by a finance scholar or a former hedge fund manager. Tony Robbins, in his 2014 work titled "Money, Master the Game", taps into his network and picks the brains of investment powerhouses, including Carl Icahn and Paul Tudor Jones, to teach simple but powerful lessons about the world of investments and, most importantly, about financial freedom.

However, it was Tony's interview with Bridgewater Associate's founder Ray Dalio that caught my attention and had me thinking the most. For those unfamiliar, Bridgewater Associates, my former employer, is the largest hedge fund in the world and the inventor of the now well-known risk parity strategy to portfolio management, which the firm branded "All Weather" in 1996.

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Source: vebidoo.de and Business Insider

At the core of the risk parity approach lies a few key ideas about asset allocation. First, few people are (or maybe no one is) able to accurately and consistently predict in which direction the economy is heading, and attempting to make bets on such predictions exposes investments to too much risk. A good allocation strategy, therefore, is one that produces relatively high returns without the extreme ups-and-downs brought about by the different economic environments. Second, a balanced portfolio is one that properly distributes risk, and not investment dollars, across different asset classes. For instance, a portfolio traditionally allocated 60/40 between stocks and bonds may look balanced on the surface, since the dollar amount invested looks well distributed. However, stocks are much riskier than bonds (nearly 3 times as much), so the 60/40 portfolio is in fact much more exposed to the volatility of equities than it looks. If stocks go down hard, the overall value of the portfolio likely will as well.

In his interview with Tony, Ray - using his trademark simplicity - laid out the exact asset class allocation that an unsophisticated investor can replicate to achieve results that are similar to those of Bridgewater's All Weather fund (i.e. returns with comparatively less risk). The allocation is very simple: 30% equities, 40% long-term Treasuries, 15% intermediate-term Treasuries, 7.5% gold and 7.5% diversified commodities. Tony Robbins calls this the "All Seasons" portfolio.

Tony back-tested this simple portfolio strategy to the pre-Depression years. The results of the back-testing were not fully disclosed, but the information that is available indicates that the "All Seasons" may be a superior investment strategy to most others available to the average investor. The table below summarizes how the returns and volatility of the All Seasons fare against those of the S&P 500 over different periods of time.

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Source: DM Martins Research, using data provided by Tony Robbins' book "Money, Master the Game"; author and finance blogger Ben Carlson, CFA; and NYU Professor Aswath Damodaran's site

Here is a visual representation of how the All Seasons portfolio would have performed, from 1972 to 2013:

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Source: Portfolio Visualizer

Looking at the table and graph above, what catch my attention the most about All Seasons are (1) the minimal exposure that the portfolio has had to sharp drops in value, and (2) the relatively high returns of almost 10% annualized that the portfolio would have produced over nearly 40 years, while one standard deviation down would still have resulted in positive returns.

In my view, the implications of these findings are very relevant - especially to retirement planners. The All Seasons portfolio, despite its simplicity, challenges a few traditional views on long-term investment strategies, and has taught me a couple of (perhaps surprising) lessons.

Even if you are young, an all-equities approach might not be the best way to go

The farther away you are from retirement, the more money you should allocate to equities - says conventional financial wisdom. In fact, when I started investing in 401Ks, in my early 20s, all my retirement money went to stocks, much of it into riskier small cap and international stock funds. I had time on my side, and I could weather gut-wrenching losses of 30% or 40%.

While the All Seasons portfolio would have produced slightly lower returns than the S&P 500 over the long run (which, compounded over time, would have made a big difference), it is reasonable to say that its much lower volatility might make it a better investment strategy than an all-equities approach, even for long-term investors. As the table below indicates, portfolio 1 (All Seasons) has produced a much higher Sharpe ratio of 0.57 than portfolio 2 (S&P 500, at 0.37) and a better Sortino ratio of 1.27 vs. the S&P 500's 0.62.

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Source: Portfolio Visualizer

Therefore, in my view, long-term investors who are able to borrow against their invested funds to use as leverage (and who know how to do so responsibly) might be able to construct a simple, balanced, All Seasons-like portfolio that returns as much as equities, but without the same volatility. The leverage required to achieve these results would probably be minimal, considering that the historical average returns of the All Seasons portfolio has been less than 100 bps lower than those of the S&P 500.

Those investors who are uncomfortable leveraging or unable to do so could instead weigh their portfolios more heavily toward equities to create comparable results. For example, a modified All Seasons portfolio that allocates 55% to equities, 22.5% to long-term bonds, 7.5% to intermediate-term bonds, 7.5% to gold and 7.5% to commodities would have returned nearly as much as the S&P 500 over the 1972-2013 period, but with a Sharpe ratio of 0.52 (vs. the S&P 500's 0.37) and a worst-year return of -17.2% (vs. the S&P 500's -37.0%).

A risk-balanced asset allocation approach may be the vaccine against bad timing.

One other problem that, in my view, a risk-balanced portfolio helps to solve is that of bad timing. This was particularly concerning during the recession of 2008-2009, when equity investors lost over 20% in the broad U.S. index over the two-year period, while hypothetical All Seasons investors were up 5%. Or during the "dot com" bubble burst of 2000-2001, when the S&P 500 lost another 20% of its value, while the All Seasons portfolio was up 7%.

If you were thinking of retiring in 2010 and did not move your money away from an all-equities portfolio in 2007, it is possible that you are still hard at work to this day, trying to make up for lost ground. It is also possible that you panicked and sold your heavily-depreciated equities position in 2009-2010, missing out on the bull market that ensued.

Similarly, if you are just getting started investing for the long run, and used your inheritance or year-end bonus to buy equities in 2007-2008 or in 1999-2000, you probably saw the value of your investment drop off a cliff instantly. You may have lost 40% or 50% of your money, and weren't able to break even on your investment until several years later. Because compounding over the long term makes a huge difference, it is possible that you pushed your future retirement date back by several years, when you bought equities at their peak.

This is the benefit of an investment strategy that avoids large, one-time losses: the money invested is more safely guarded, and downturns in the market are unlikely to affect the investor as much in the short term. I see the All Seasons portfolio strategy, along with dollar-cost averaging, as an interesting tool to minimize exposure to significant losses that many investors cannot afford to have.

In conclusion…

The lessons learned from Tony Robbins' interview of Ray Dalio in his book can be game changing. It is true that Ray's asset allocation strategy might not sound groundbreaking to most sophisticated investors, as it does not require the use of derivatives, financial leverage (although I have argued that leverage could be deployed to boost returns), or obscure financial instruments. It is, however, an elegant approach that defies conventional wisdom in the world of investing, and may help those planning for retirement achieve better returns with less risk over the long run.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.