Ray Dalio : The Man Who Loves Mistakes
Dalio strongly believes in diversification. He calls the improvement of return/risk by adding uncorrelated assets the “Holy Grail of investing.”
To determine the dependence or independence of two assets, most people focus on correlation as the main tool. However, Dalio believes that the correlation between assets varies and depends on prevailing situations. Hence it can be misleading and unsuitable for designing a diversified portfolio.
For example, generally, gold and bonds are inversely related because inflation is bullish for gold and negative for bonds. This is because higher inflation usually means a higher rate of interest. However, an easy money policy will reduce interest rates because of which bond prices will increase. At the same time, it will increase long term suspicion of currency depreciation which will increase gold prices. Hence, both gold and bonds will move higher together during the early phase of the deleveraging cycle which is exactly opposite to their natural relationship.
Dalio believes drivers that affect a position are causes whereas correlations are the outcomes. To construct a diversified portfolio, it is important to select assets that have different drivers rather than just being uncorrelated.
Markets behave differently in distinct environments. A fundamental model that presumes fixed relationships between the market and other economic variables, is faulty because those relations can drastically change in different situations. Dalio asserts that a logical fundamental approach must be broad enough to encompass both temporal and geographical environments. He believes that this is the only approach to build an adequately strong fundamental model.
Like many other market wizards, Dalio too insists on keeping a trading journal. Keeping a note of trading mistakes serves as a future reminder and strengthens the lesson learnt from it. Mistakes provide an opportunity to learn from them and improve to achieve success. It is an essential part of continuous improvement as a trader and also for any other attempt.
