Reducing risk and volatility without reducing return?
Investing Pioneer – 04/14/2023 – 1:50 PM EST
When talking about the role of diversification in a portfolio, it’s usually referred to as a passive measure to serve as an insurance policy against concentrated failures, be it within an industry/sector or specific company, at the likely cost of outperformance. Warren Buffett says diversification is a hedge against stupidity. However, according to Ray Dalio, founder of the hedge fund Bridgewater, if diversification is implemented correctly, its a “holy grail” of investing.
Why?
Because risk and volatility can be reduced, without reducing return.
For some, this may seem like a paradoxical idea.
“Sure, it may be possible. But crafting a portfolio that achieves equal, or even higher than expected returns, while radically minimizing risk is best left to top portfolio managers like Dalio and his extensive team, no?”
Not necessarily. The principles are simple, and some investors can successfully implement them to build a more robust portfolio. Presumably, such a strategy would lend itself extra useful for those approaching or in retirement age. In other words, those who are reliant on whatever sum of assets and cash they have at present, yet don’t want to underperform the market.
For the younger investor, who is investing on the side, for the long term, and is not overly dependent on their portfolio, volatility is less of an issue. A 50% drawdown in indices might scare most investors, but for younger individuals, it’s simply an opportunity (maintaining buying power during significant drawdowns however can lead to significant outperformance, if ones “diversification strategy” worked as planned).
On the most fundamental level, Dalio’s strategy involves selecting quality assets, that hold sufficient probabilities for sufficiently high future cash flow, based on historical data and core principles. To almost maximize the effects of diversification while retaining the benefit of concentrated bets to outperform: 10-20 uncorrelated assets. Often, people misinterpret this, and only buy stocks. However, as most stocks tend to be somewhat correlated, they must span beyond merely traditional stocks. Particularly during tail-end events. Think bonds, real estate, precious metals, etc.
Notice how I mentioned precious metals? Metals, of course, do not produce future cash flow. Unless one regards any profits from the sale of a holding as cash flow. During highly inflationary periods, the utility value, across time, of gold and silver can be exceptionally high. Simply because it allows you to potentially purchase assets at a bargain, when almost all other assets are depressed, in real (inflation-indexed) terms.
Such instances are rare. But as Ray Dalio often says, we overestimate the probability of events that we have experienced in our lifetimes and underestimate the probability of events that have not happened in our lifetimes. Given the current financial and monetary environment, I think the probability of galloping inflation occurring is higher than normal. I recommend against taking these words or any other standalone statements like these at face value.
“From my earlier failures, I knew that no matter how confident I was in making any one bet I could still be wrong – and that proper diversification was the key to reducing risks without reducing returns.”
–Ray Dalio, Principles
As an active investor who makes a series of conviction plays every so often, you might wonder how often you need to be right. Of course, when such statements are made, the well-known “time in, not timing” comes in. John Bogle was the leading proponent for indexing returns to make your fair share in the market.
To have some value, clarifying what adheres to the definition of time in the market vs timing the market should be done. At one end of the spectrum is completely passive broad-based index investing, dollar cost averaging over time with available income.
If this is the only definition of time in the market, it leaves little room to ponder investments so that one can beat the market. For the most part, beating the market is the reason someone actively invests, other than maybe the enjoyment derived from the challenge and the journey.
I digress. Going back to how often one needs to be right if the risk is managed correctly, it doesn’t have to be 80%, 70%, 60%, or even 50%. Of course, this depends on the context and the level of risk and return associated with these investments.
Back to Ray Dalio, in his book, says, “This new approach improved our returns by a factor of three to five times per unit of risk, and we could calibrate the amount of return we wanted based on the amount of risk we could tolerate.”
Presumably, with such a strategy, one can obtain the best of both worlds. Minimizing the risk of getting “knocked out of the game” (as Dalio says), is a characteristic associated with passive investing, with the returns possible via active investing.
I’ll leave you to ruminate on this quote by Dalio, “The success of this approach taught me a principle that I apply to all parts of my life: Making a handful of good uncorrelated bets that are balanced and leveraged well is the surest way of having a lot of upside without being exposed to the unacceptable downside.”
