The ideas, as published
Everything in this section is a paraphrase in this site’s own words. Nothing is quoted. The works it comes from are listed in the next section.
- The economy as a machine.
- The paper How the Economic Machine Works describes an economy as the sum of its transactions, and credit as the part that makes it cycle. It separates three things: the slow growth of productivity, a short debt cycle of several years, and a long debt cycle of several decades.
- Prices already contain a forecast.
- An asset’s price reflects what people expect. What moves it is the difference between what happens and what was expected. A strong economy that was fully expected changes little; a surprise changes a great deal.
- Two surprises make four environments.
- The firm’s paper The All Weather Story reduces the surprises that matter most to two: growth and inflation, each of which can come in higher or lower than expected. That gives four environments.
- Each kind of asset leans towards an environment.
- In that account, shares tend to do well when growth is stronger than expected and inflation is lower. Ordinary bonds tend to do well when growth is weaker and inflation falls. Inflation-linked bonds and commodities tend to do well when inflation rises. These are tendencies seen in past data, not rules.
- Balance the risk, not the money.
- A portfolio split between shares and bonds by money gets most of its swings from the shares, because shares move more. To balance by risk a portfolio must hold much more of the steadier assets, and in practice it borrows to do so. The firm has said it began managing money this way in 1996.
- Many unrelated sources of return.
- In Principles Dalio writes, in paraphrase, that holding a number of good return streams that do not move together reduces risk a great deal without reducing the expected return, and that finding them is the most valuable thing in investing.
- Write the rules down and test them.
- Principles describes turning decisions into written rules, testing the rules on long histories and across countries, and recording mistakes so that they can be studied instead of hidden.
The sources
Named by title, author, publisher and year so that they can be found and checked. No links are given.
- Principles: Life and WorkRay Dalio. Simon & Schuster, 2017.Used here for: His own account of 1971 and of 1982, the value of unrelated return streams, and written rules.
- How the Economic Machine Works: A Template for Understanding What Is Happening NowRay Dalio. Bridgewater Associates. The paper was circulated from about 2008 and revised afterwards; a short animated film of the same name followed in 2013.Used here for: Transactions, credit, productivity, and the short and long debt cycles.
- The All Weather StoryBridgewater Associates. Bridgewater Associates, about 2012.Used here for: The four environments, the lean of each kind of asset, and the start of the approach in 1996.
- Principles for Navigating Big Debt CrisesRay Dalio. Bridgewater Associates, 2018.Used here for: The long debt cycle worked through historical cases.
A documented example: August 1971 and the decade after
On the evening of Sunday 15 August 1971 President Nixon announced that the United States would no longer exchange dollars for gold at a fixed rate. Dalio writes in Principles that he was working on the floor of the New York Stock Exchange that summer and expected shares to fall on the Monday. They rose sharply. He writes that the surprise sent him to study earlier cases, and that he found the same pattern in 1933.
The decade that followed is the usual illustration of why the environment matters. Inflation in the United States rose through the 1970s, with oil shocks in 1973 and 1979. A mix of shares and ordinary bonds lost purchasing power over much of that period, while gold and other commodities rose. From the early 1980s inflation fell for many years, and shares and bonds both did well.
The same mix of holdings was a poor portfolio in one decade and a very good one in the next. Nothing about the holdings had changed. The environment had. A portfolio of shares and bonds looks diversified when they move apart, and in a period of rising inflation they have tended to fall together, as they did again in 2022.
1982: a forecast that was wrong, by his own account
In August 1982 Mexico announced that it could not keep up the payments on its debts. Dalio had been warning of a debt crisis, and he writes in Principles that he became confident a depression would follow. He said so in public, including in evidence to the United States Congress and on television.
He was wrong. The Federal Reserve eased, the American stock market began one of its longest rises that same month, and the economy recovered. He writes that the losses were large enough that he had to let everyone at the firm go, and that he borrowed 4,000 dollars from his father to pay his bills.
He describes the episode as the origin of much of what came later: asking how he could know he was right instead of assuming it, looking for people who disagreed, and spreading bets so that no single view could do that much damage again.
The approach has its own weak point, and the record shows it. Balancing by risk means holding a large amount of bonds, often with borrowed money. In 2022 inflation and interest rates rose together; shares and ordinary bonds both fell, and inflation-linked bonds fell as well, because the yields on them rose. A portfolio built to have no bad environment had one.
What can be studied with a small paper portfolio
What can be examined on paper is the question the method asks: which environment does each holding depend on, and how much do the holdings move together? The exercise uses invented holdings.
- Write down a hypothetical portfolio of four holdings. Beside each, write which of the four environments you think it leans towards. If all four lean the same way, it is one holding in four parts.
- Open the correlation machine in the Risk Room. Set four holdings and move the slider from no relation to moving together. Record how the combined swing changes while the holdings themselves do not.
- In the inflation calculator, enter an invented sum and two different rates of inflation over ten years. Note what the difference does to what the sum will buy.
- Write one paragraph on what would have to happen for all four of your holdings to fall in the same year.
- The Risk Room: correlationTwo to four invented holdings, and how closely they move together.
- Inflation calculatorWhat a sum will buy later, at a rate you assume.
The correlation between real holdings is not fixed. It has often risen in a crisis, which is when the spread was wanted. A slider cannot show that.
What does not scale down to a private account
- Financing terms
- Balancing by risk needs borrowing against the steadier assets, at the rates large institutions pay in the futures and repurchase markets. A private person borrows at a higher rate, if at all, and the loan can be called.
- Derivatives access
- The approach uses futures, swaps and inflation-linked bonds across many countries, under legal agreements negotiated with banks. Few of those are open to a private account, and fewer at a cost that leaves the arithmetic intact.
- Liquidity
- Keeping dozens of markets in balance means dealing in all of them regularly. An institution does that at very low cost per trade. For a small account the dealing costs can outweigh the benefit of the balance.
- Information and staff
- The rules are built and tested by a large research staff on long histories of data from many countries. A private investor cannot test an idea in that way, and a rule that has not been tested is only an opinion.
- Tax treatment
- Frequent rebalancing and the use of derivatives are taxed differently from simply holding, and the rules depend on the country.
- Time horizon
- The clients of such a firm are mostly institutions investing for decades. An environment can last ten years. A person who needs the money sooner can meet the wrong one and have no time to wait for another.
- Several leveraged CFDs are not a balanced portfolio
- A contract for difference on an index, a bond or a commodity is not ownership of any of them. Each is usually leveraged, each usually carries its own financing charge, and each can be closed out separately by a margin call. Holding several does not reproduce a portfolio balanced by risk.
Questions people ask
- What are the four economic environments in Ray Dalio’s framework?
- They come from two things that can each surprise in two directions: economic growth higher or lower than expected, and inflation higher or lower than expected. In the published account, shares tend to do well when growth is stronger than expected and inflation is lower, ordinary bonds when growth is weaker and inflation falls, and inflation-linked bonds and commodities when inflation rises.
- What is risk parity?
- It is a way of building a portfolio so that each kind of holding contributes a similar share of the portfolio’s swings, instead of a similar share of its money. Because bonds usually move less than shares, that means holding far more bonds, often with borrowed money. It reduces dependence on shares. It adds a dependence on the cost of borrowing and on bonds not falling sharply.
- Did Ray Dalio ever get a big forecast wrong?
- Yes, by his own account in Principles (2017). In 1982, after Mexico said it could not pay its debts, he publicly forecast a depression. The economy recovered and the stock market began a long rise. He writes that he lost so much that he had to let his staff go, and that he borrowed 4,000 dollars from his father.
The words on this page
A summary for study of ideas that are on the public record, in this site’s own words. It is not endorsed by, or connected with, anyone named. Nobody at GIO4X has access to their portfolios. Studying a method does not reproduce its results, and a leveraged CFD is not ownership of an investment and does not behave like one. Educational information, not investment advice or a recommendation to trade.