I believe that studying the great investors—regardless of their particular specialty—can provide the retail investor with key insights into how to invest successfully. These insights can then be developed into actionable principles to guide one’s investment decisions. In that spirit, I’d like to share 5 simple but highly-effective lessons we can learn from Ray Dalio and apply to our own dividend-growth investing to take it to a higher level.
Dalio is the founder of the investment management firm Bridgewater Associates—launched in 1975. The firm has grown to over $150 billion in assets under management. Under Dalio’s tutelage, the firm has developed and introduced “numerous innovative investment strategies, including currency overlay, inflation-indexed bonds, super-long duration bonds, global bonds and emerging market debt” (source).
Arguably more importantly, the firm helped to pioneer two key investment developments. First, the firm “pioneered the separation of alpha and beta” investments (source). Secondly, it pioneered the risk parity approach to portfolio management, including the launch of its All Weather hedge fund.
While Dalio is a hedge-fund investor and his firm works strictly with institutional investors, the principles that have shaped his investment decisions provide nuggets of value for retail dividend-growth investors—nuggets that can be effectively incorporated into our own portfolio management.
One of Ray Dalio’s overarching principles is that we need to accept and learn from our mistakes.
Throughout our formative years, the educational system penalizes mistakes and rewards perfection. Unfortunately, life—and investing—doesn’t occur in a highly-controlled classroom environment. To the contrary, both involve complex decisions and chains-of-events. As such, mistakes are guaranteed and far more frequent than success early on.
Success in life and investing (rather than in school) is all about making mistakes and learning from them. Our ultimate grade in life is not so much tied to how many mistakes we make but, rather, what we do with those mistakes.
When we encounter a mistake in our dividend-growth investing plan and strategies, we need to quickly recognize it and effectively react to it. By embracing mistakes and problem-solving both how they occurred and how we can avoid them, retail investors can develop their own investing principles—principles that will produce long-run success.
Warren Buffett echoes Dalio when he highlights the tendency of investors to hold on to things (e.g., plans, strategies, positions, etc.) in order to justify past decisions. He often jokes about textiles—noting that he got into them in 1965 and didn’t throw in the towel until 20 years later… about 20 years too late by his own admission!
Dividend-growth investing is both an art and a science—both dealing with a probabilistic system. As such, we are guaranteed to make mistakes. Our ultimate success comes from recognizing when our theses are wrong, figuring out why, and then changing our approach so we don’t repeat the mistake.
It does no good to ignore a mistake. Sweeping them under the carpet will only compound the problem. Furthermore, holding on to past decisions is equally irrational and damaging. If we made a bad decision, it isn’t likely to suddenly become a good one if the underlying premise has failed!
We need to accept that we made the best decision possible at the time, but that new information now allows us to make a better one—we just need to effectively analyze that information and make a BETTER decision now.
Over the years, I’ve realized that there is a tendency within the investing community to immediately attempt to disprove and/or discredit anything that is presented.
I can publish an in-depth article explaining why doing A with your portfolio may help you get to point B and, before you can take a breath, folks will come out of the woodwork slamming action A and advancing a million reasons why you shouldn’t do it. And, very few of them even bother to listen and understand my rational for it—they don’t care… they just want to prove it wrong.
While professional skepticism is an important component of our decision-making process when it comes to investing, we need to remember that “professional” includes carefully analyzing and considering that which is being proposed—it doesn’t mean irrationally dismissing everything without thought and based solely on prejudice or bias.
If all we do is seek to disprove ideas, we will never identify ideas that may actually work. We will be left with a million things not to do, but nothing TO do.
It is this behavior that Ray Dalio frequently warns against. He argues that the student should always listen to and seek to understand the teacher first… and then test the validity of their assertion. Afterall, you can’t test something you don’t fully know or understand!
Dalio is not implying that teachers are always right. Rather, he is simply arguing that we’ll never know when they are right if we just challenge and dismiss them right out of the gate rather than first listening to their teaching and trying to understand their ideas.
As dividend-growth investors, it’s important that we are open to ideas—especially from those who have investing knowledge and experience.
We should never just accept those ideas or act on them without fully analyzing them from a position of professional skepticism—due diligence is always critical. However, we should always be willing to listen and seek to fully understand the idea being presented before we scrutinize it.
It’s easy to become jaded in investing—especially when you’ve faced a string of failures. However, while naivety should be avoided, allowing oneself to become jaded is equally perilous. Investing success requires a healthy psychological balance.
I can “prove” just about anything valid to myself… but I can also “prove” that same thing invalid. You know what they say about statistics! Effective learning in investing requires approaching ideas from both directions. A system of due-diligence that only encompasses one perspective will likely fail you in the long run.
I like to first fully understand an idea and then (a) “prove” why it works and (b) “prove” why it doesn’t. I then compare the two before proceeding. This helps identify parameters or conditions that may impact when or why the idea works or doesn’t—and it pushes me to challenge my own thinking and biases.
Listening first and challenging second will enable us to not only identify (and avoid) bad ideas but it will, more importantly, help us recognize good ideas—ideas that we can learn from, integrate into our own investing, and, ultimately, improve our investing and performance.
The third investing lesson we can glean from Ray Dalio is that we need to have a contrarian mindset.
As Dalio often quips, success requires us to bet against the consensus and be right.
The consensus opinion at any point in time is reflected in the price—it is referred to as beta. If we want alpha (out-performance), we will never get it by following the herd (consensus). Rather, we must be willing to take a contrarian position when warranted.
This lesson is simple in theory but hard in practice! However, it lies at the heart of value investing and, therefore, is a key ingredient to successful dividend-growth investing.
Simply put, we want to identify stocks where the consensus opinion (market price) is below what we believe the true value of the company is. This represents a potential over-reaction by the herd and potential alpha for us if we are right.
Obviously, the hard part is being right! If we’re wrong (and the herd is right), then we are in what’s known as a value trap.
The point is that simply following the herd won’t allow us to achieve long-run alpha. We have to take some contrarian positions—based on careful analysis.
We won’t always be right (see lesson #1); however, as Buffett says, if we’re really right just 3 or 4 times out of 20, then we’ll do very well in the long-run! (Much better than if we had just followed the herd)
The fourth lesson we can take from Dalio is to properly diversify our portfolio.
Dalio points out that there are two fundamental strategies: strategic and tactical.
Strategic strategies are macro, long-term plays. The underlying thesis behind these is that asset classes on-average will out-perform cash (except in a depression). This is why Buffett states that cash is a BAD investment and encourages everyone to get out of cash and into assets.
Now, you obviously want some cash around—it’s like oxygen. You need it for liquidity and to be able to capitalize on great opportunities when they present themselves. However, you don’t want any more than you need.
An example of this is the large amount of cash Buffett is currently sitting on at Berkshire Hathaway. He typically loves to have his money working (i.e., invested in assets); however, it indicates that he believes the market is currently over-priced (on-average) and he wants dry powder available when value presents itself.
The point is that when that value presents itself (and it will), he will reduce his cash reserve and invest in strategic asset positions.
Tactical strategies are micro, short-term plays. By nature, and unlike strategic plays, they represent a zero-sum game. For you to win, someone else must lose (or visa-versa). As such, these are higher-risk strategies.
Dalio’s approach is to diversify and balance appropriately.
First, from a balance perspective, he advises to allocate a small portion of your capital to tactical strategies—you have a higher potential to lose with these.
The majority of your capital should be working in strategic strategies—which do not represent zero-sum games. In other words, while there will be periods of volatility, over long periods of time, these investments have a high likelihood of producing positive returns.
Secondly, to minimize strategic portfolio volatility, Dalio recommends effective diversification across asset classes. In fact, he developed his All Weather portfolio strategy to do just this.
While it won’t produce the highest returns, what this portfolio strategy will do is minimize the downside risk, while maximizing the likelihood of long-run positive outcome.
We’ll look more closely at this specific strategy in the final lesson; however, the point with this lesson is that we need to ensure we have adequate diversification in our dividend-growth portfolios and that we are focused primarily on strategic—rather than tactical—plays.
Most retail investors (including short-sighted dividend-growth investors) get burned because of tactical plays—not strategic ones.
This is why, over the past 20 years, the average retail investor has not only massively underperformed the markets but has actually managed to underperform inflation—they over-allocate capital to tactical plays and fail to effectively diversify their strategic portfolios!
As a dividend-growth investor, always diversify and play the long game.
If you’re interested in learning more about diversification, I encourage you to read my article Sector Rotation: The Case for Dividend-Growth Portfolio Diversification.
The final lesson we can take from Ray Dalio is that we must manage our portfolio in a way that keeps us in the game.
As I eluded to in the introduction, one of the great advances that Dalio developed was the risk parity investment approach.
In essence, Dalio argued that balancing (or diversifying) a portfolio based on value was not an effective approach. Rather, it should be balanced based on actual risk.
I’m sure you’re familiar with the common industry portfolio allocation recommendations, such as the 50/50 or 60/40 stock-to-bond allocation. Risk parity argues that these approaches mask the actual underlying risk these portfolios present.
The reason why is that equities are three times more volatile than bonds. So, if you think you are balancing your risk with a 60/40 allocation—you really aren’t! You are exposed to much more volatility risk than you think you are—or are being told.
Rather than the typical portfolio allocation advice available, Dalio developed his All Weather portfolio strategy to properly balance actual risk. Here are the basic (albeit simplified) allocations:
Dalio’s goal was to develop a strategy that minimized downside risk, while producing a reasonable average return—producing an all-weather portfolio.
Portfolio Charts is a great (free) online resource for exploring different portfolio allocations and strategies. The site provides a number of great charts that provide you with an intuitive look beyond the raw numbers.
They have a number of pre-built portfolio strategies you can browse—including Dalio’s All Weather portfolio. Below are three different charts that demonstrate the effectiveness of his risk parity approach:
Why does this matter? Simple, we want to build portfolio strategies that match our unique risk tolerance!
The point is not that the Dalio “All Weather” approach is right for you.
Rather, the lesson is to make sure we are managing actual risk—regardless of what strategy we are employing.
Failing to do this will introduce volatility that can quickly exceed our given risk tolerance—leading to emotionally-driven decisions with almost-always bad outcomes.
Again, this is why the average retail investor has produced horrible returns during the greatest bull market in history. They didn’t stay in the game!
Volatility will come—even during great bull markets. When it does, you will learn—ready or not—the real risk inherent in your portfolio. When this real risk exceeds your stress limits (which it often does for retail investors), you are far more likely to exit positions at the worst possible times—taking losses.
There is no perfect, one-size-fits-all portfolio. You have to find your own path. The lesson from Dalio is make sure you are managing your actual portfolio risk in a way that keeps you in the game!
If you’re interested in learning more about managing your portfolio risk, I recommend reading my article Idiosyncratic Risk: Is Your Portfolio Really Protected?
While Ray Dalio is a hedge-fund investor and not a dividend-growth investor, he has been highly successful and there are fundamental principles we can borrow from his investing and integrate into our own style and strategies—principles that can materially improve our performance.
Five fundamental lessons we can learn from Dalio as dividend-growth investors are:
While these investing lessons are qualitative in nature, it is critical to understand that psychology plays a critical role in our overall investing success. I love the quantitative side of investing as much as you probably do, but we must be careful to remain on guard against failing to develop effective qualitative principles as well!
If you’re interested in learning more about the psychological side of investing, I highly recommend reading my article Finding Your Dividend-Growth Investing Zen: 6 Tips to Win the Mental Game.
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