Thoughtful Capital Group: Systems thinking for institutional allocation

Ray Dalio founder of Bridgewater Associates & Bloombergs Erik Schatzker

Bloomberg 50 in Finance September 15th.
http://www.youtube.com/watch?v=ze_zDhnc_ns&feature=player_embedded Male:

Next on our agenda, I am very pleased to have the founder of Bridgewater Associates, Ray Dalio, join us today. I would say a thought: when we created our Most Influential list, we avoided ranking them from 1 to 50. I thought that would be false precision. I wanted to avoid that. And I also figured thats why God created alphabetical order when youve got a list like that. We did have the task, though, of choosing in each of our five main categories, somebody to profile. And in the money manager group, it seemed very obvious to me that the choice could be none other than Ray Dalio, Hes had a 20-year record that is incredibly successful. Plus there is always the Bridgewater daily observations, which I think many in the room will be familiar with. Ray will be interviewed today by the cohost of Bloomberg Televisions Inside Track. Somebody who I have had the pleasure of working with for about a decade, I believe. So Eric Schatzker, take it away. Eric Schatzker: Thank you very much, Rob. Good morning, everyone. Nice to see you here. Ray, thank you for joining us. Folks, I have the suspicion that many of you in this room, if not most, perhaps all, know a little bit about Ray Dalio. And thats why youre here. First, you know that hes a hedge fund manager but he is not unlike or like, I should say other hedge fund managers. Ray, you operate according people have probably heard this before you operate according to a set of principles, precepts you might call them. A series of templates, a framework, if you will, for understanding everything from the economy to personal relationships. People here know, Ray, that you have, as Rob just alluded to, delivered some astonishingly big and consistent returns; some 15 percent a year for almost 20 years in your biggest fund. And on an extraordinary scale. Bridgewater
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Thoughtful Capital Group: Systems thinking for institutional allocation

Associates, his firm, manages more than 120 billion dollars. And they know that you predict a long and painful recovery for much of the developed world, especially the peripheral EU. What they have come for, though, is a taste of the secret sauce. So first I want to give you an opportunity, if you will, to briefly explain what a principle is. Because it is going to be central to our conversation. And the principles are often confused for something else. So set us straight. Ray Dalio: Okay, so I dont mean an esoteric kind of thing and I dont mean to be lecturing to people about what their principles should be. I just want to clarify that what I mean by principle means a description first of all, an understanding of what reality is and how reality works. Reality works in a certain way. And so, for example, theres an economic machine. When we are talking about the financial crisis or were talking about the leveraging, there is a machine. The machine works in a certain way. Can we describe how the machine works? We should be able to describe how the machine works, how does the leveraging work. And then we also should be able to say, given that reality works that way, what is my principle for dealing with reality? A principle means how do you deal with reality to get the outcomes you want? So that can apply to any part of life. If you are learning how to ski and you say put your weight on the downhill ski, its just a reality that that will help to make the turn better. So what are your descriptions and means of dealing with reality so you get what you want thats all I mean. ES: Many of us here are interested in understanding most and they can go and read about your principles for life, your principles for management, and perhaps even a bit about your principles for the economy, and Ill get to that at the end. They want to know a bit more about your principles for investing. Can you give us a few good examples? RD: Okay, an example would be Ill call it what I call the Holy Grail. If you get this, you will get all the riches in the universe. Or
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Thoughtful Capital Group: Systems thinking for institutional allocation

youll make a lot of money. That is, if you have 15 or more good, uncorrelated return streams that the math of that is such that if you go from 1 to 2 uncorrelated return streams. That you will reduce your risk by about 80 percent at about 15. And theres a certain math to it; theres a certain structure to it. If I was to show you a chart, I could describe mathematically. So for example, if I had return streams that were 60 percent correlated, and I had a thousand of them, I would only reduce the risk by about 15 percent. And after five or six, its limited. So theres a certain notion when approaching investing. What do I want? I need to have a certain structure. That can come in the form of alphas and betas. What is my risk neutral position? Ill say everybody in the room, they say what should I invest in? They dont start off, I think, with what is a neutral position. What represents a good neutral position, balance? For example, does gold represent a part of my portfolio? What should, if I had no view, what should the concentration in dollars be? What is a structural beta portfolio? And then how do I take a deviation from that beta portfolio which is the alpha, in order to add value? And how do I do that in an uncorrelated way, so that I can then maximize my return to risk? So in that first principle, what Im saying is that if you follow that first principle and you get 15 good -- dont have to be great uncorrelated return streams, youll improve your return to your risk by a factor of 5. That means five times the return for the same amount of risk. Thats just a principle; thats a reality. Everybody would agree on the math of it. And then that will determine an action. So what am I going to do when Im reading my portfolio. That will influence the way I structure my portfolio to get what I want. ES: People say that correlation among different asset classes is increasing, making the job of being a macro hedge fund manager harder. Is that true? RD: No. So I think that there Im worried that we can digress into the nature. I think that there is an intrinsic characteristic that determines the returns of asset classes. So a very simple example would
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Thoughtful Capital Group: Systems thinking for institutional allocation

be if you knew that the, if inflation was to come down by a certain amount, you multiply that times the duration of the bonds, and all things being equal it will carry over to the bond return. And so that there is a certain structure that exists in asset classes. There is no such thing as an intrinsic classic correlation. So the relationship between bonds and stocks, for example, could either be positively correlated or negatively correlated, depending and both of them make sense if you know what determines the pricing of that asset class. Bonds are always logical in that way. Stocks are always logical. But if you come into a time, for example, when economic uncertainty and volatility is greater, then they will be negatively correlated. If you are in a period of time where inflation uncertainty and volatility is greater, they will be positively correlated. Both of those things are logical if you know how they behave. Therefore it is that understanding, not a fixed notion that there should be a correlation. That fixed notion of a correlation doesnt exist. Theres no such thing as correlation; theres only the logical behavior of each of those two markets that then will determine its relationship. And so when I say uncorrelated asset classes, what Im really doing is not using the classic measure of correlation, like stocks and bonds are 40 percent correlated. What I am instead really referring to is, do you know how they behave, and is it intrinsically going to behave alike or differently? ES: Many other call them macro-managers thats unfair, not many very few have had great runs of consistent big returns. George Soros, Bruce Kovner, came down as of this week. Is what they do comparable to what you do? Some of what you just described? RD: I dont know enough about exactly what they do to comment on that. I could better answer your question if it is directed more toward what I do. I would describe some things that I do that I think might be done different. I think that every transaction, every price of anything, is a function of a transaction. Theres a transaction that takes place. And that that transaction is an exchange between buyers and sellers. And what happens is that a buyer gives money and a seller gives the
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Thoughtful Capital Group: Systems thinking for institutional allocation

thing. The thing being a stock or a widget. And that the price of that will be a function of the total amount of the buyers spending divided by the quantity of things exchanged. And if I can go down and understand the behavior of those, then its all logical and it makes sense for me. So for example in the financial crisis. There is nothing surprising about the European debt crisis. It should be no surprise. Because the payments were due. In other words, we could take the payment streams, you know it; the maturities are going to happen here, and theres this quantity. This whole notion that there is a perception, like faith, does not make sense. Because its not like that. Every day there is an exchange. And if you look at all the reasons for that exchange, there are some reasons that -- some are allowed to own this. Or lets say banks buying. Banks, when they buy bonds, have limitations. So because they bought a certain amount of bonds over a period of time when they could expand their balance sheet, does not mean that they continue to do that. Because they cant expand their balance sheet. So therefore you could not have that same amount of buying, and thats that number up to the amount of selling that needs to happen. Is there a gap? It was apparent, I think. Should be apparent, if you do the numbers, that there would be a gap. How big is the gap? Who is going to fill the gap? ES: So what does that mean? Lets follow that point for a moment. If the financial crisis in Europe, and whats taking place thus far, whats happening now, is not surprising, what else wont surprise you? In other words, what is almost a foregone conclusion in the sense of what has to be done to solve the problem? RD: I think that the most important thing that we should have is a quality conversation of how the machine works. In other words, there are two levels I can answer that question at. What needs to be done? Well, the choices are you can either transfer wealth from the rich to the poor, or you can print a certain amount of money, or you can write down the debt. And you can go through and you can figure out which of those you want to do and thats one more choice. The biggest
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Thoughtful Capital Group: Systems thinking for institutional allocation

problem, I think, is not having a quality enough conversation at the higher level of how does a machine work? What are the choices? What has happened before? The IMF you just have to go through a list of sovereign restructurings. Theres a certain process; it works a certain way, for good logical reasons. Do you understand how the machine works? And I think that the thing that has to be different is the stepping back, generally. Understand. How does it do leveraging work? How does the economic machine work? And therefore what is going to happen? How does politics work? Ray Dalio: How does politics work? Politics, the history of democracies when we have economic crisis, there is greater polarity in democracies, and then it becomes less functional this is very normal. Hitler came into power in 1933 because there was disorder in a democratic system in a depression-type environment. So all of those that's how the machine works, and the machine basically so let's have a quality conversation of how does the economic machine work, the political machine work, and then if you understand that (that's what I mean, 'reality principles'), then you can know how to deal with it. ES: Well, does understanding how the machine works lead to a better outcome? Ray Dalio: Yes. ES: Or, it does. Ray Dalio: That's the essence, right? In other words, everything in life . . . ES: But is the outcome necessarily, is the outcome at all good? In other words, if you talk about transfer of wealth, reconstruction, monetization of debt, all of those have unpleasant consequences.

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Thoughtful Capital Group: Systems thinking for institutional allocation

Ray Dalio: Oh, I'm not saying that everyone gets what they want in life. I'm saying that the best choice everyone is faced with choices, they have their circumstances. And then the question is: how well do you make your choices? So, do you understand what reality is? OK. No, you can't make the old party that everybody's going to borrow a lot of money and have a party. Those days are g-, you can't do that again. You can't continue, you run out. So a deleveraging in a very simple sense is let's imagine that you take a moment if I can to explain it. Let's imagine that you have, you earn $100,000 a year and you don't have any debt. Then you can go to the bank and you can borrow $10,000 a year; you can spend $110,000 a year. When you're spending $110,000, somebody's earning $110,000, and you could continue to do that for a number of years. If you do that your debt will rise relative to you income. It doesn't mean you could do this forever. Your debt will rise relative to your income, and then you will get to a point where your debt service cannot service that. You can alleviate that by lowering interest rates. Lowering interest rates has a certain effect; then you get to something where you can't lower interest rates . .. ES: Where we are now? Ray Dalio: And then what you're going to have to do is print money and so on. This has consequences, so that when you reach the point where you can't do it anymore and the way it always works is it's always the private sector first, always through the banks. So the banks leverage up; it's not a velocity of money thing, there's no such thing as velocity of money. You can make credit out of thin air. If you go into a department store and you buy something like a suit, and you could sign your credit card and you can walk away, you have created credit. Credit is a promise to deliver money. It will produce GDP but you'll create credit, and that's the way the machine works. So you reach a certain point that you can't do that anymore. Now, if you're asking me can we can go back and continue to do it, we can't go do that, but we can understand the reality of it. And we can then say: how do we deal
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with this in a logical way? There's no reason to be surprised at all of this. There are choices. And how do we best support, apportion the money? How much is going to be transferred? So, you know, there's a certain amount through the ESFS; there's that number. Just do the numbers. Then how much of it is going to be essentially money creation, or let's say, the expansion of the balance sheet (the private credit by the ECV)? Or, how much of it is going to be restructuring? Let's get those numbers right; let's look at it, make sure it's orderly. That is a better path I think than the path that we're on now, which is, like, every day is a big surprise. ES: [laughs] If a better outcome is possible, why are you so, call it pessimistic, about the prospects for a peripheral Europe? Ray Dalio: Well, so there's two basic paths here that influence my outlook: will that be done well or will it be done poorly? That's the first thing. If it's done well it means that peripheral Europe's party is over, and so they're going to have to go through a managed deleveraging, very much analogous to the Latin America of the '80s. In other words, you can have a scenario that will be the lost decade in Latin America. In '81 we have the crisis, '91 we have the Brady Bonds restructuring, and we go down a path that's like that. OK? The party's over though. Or you can have something that is worse and badly managed. So that's why I'm pessimistic. You would say one of those things is going to happen, and the question is, is it orderly, is it well-managed? And, you know, it's one of those. ES: Does the situation we face here in the United States in any way resemble the prospects for Europe, or is it, I hesitate to say, considerably better? Ray Dalio: I think it's better because we can print money. OK. So let's break the world into two . . . ES: And that's a good thing right now?
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Ray Dalio: Oh, it's a handy thing to have! It really is. So let's break the world: there are two worlds. There are debtor-developed countries. ES: Like this one. Ray Dalio: Like this one. The debtor-developed countries who've reached their ends of their long-term debt cycle and have to manage this problem, and also remain uncompetitive because they're still running deficits. Those deficits mean they add to the pile of debt. Then there's the others, the emerging creditor countries. Enter China China walks onto the scene. OK? So emerging creditor countries which are in the opposite position. Those two worlds can each be broken into two types: those that can print money, those who have independent currencies and monetary policies, and those that have linked currencies and monetary policies. Those that have linked if you're a debtor and you have a linked, and you can't print, you are crashing and you have a deep problem. On the other end of that spectrum, if you are a China and you can't stop printing because you have a linked exchange rate, you have a bubble issue you have a debt-bubble issue going on. So both of those extremes have the opposite kind of problems. Because they have inappropriate currency they can't make the adjustments. They can't have the right currency, they can't have the right interest rate, they can't have the right fiscal policy the fiscal policy won't do it. Then there are those that can move their currency. So if we're looking at where might we be better off, our attention turns to the Fed, right? In other words, if the markets are going to rally and things are going to be good, it's going to be the Fed that's going to come in and save us, right? ES: Is it? Ray Dalio: It OK. That's another topic.

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ES: Well, OK. I don't know if we can get into that one, but let's describe what you just laid out. Ray Dalio: But that's the difference, right? ES: China versus, call it Greece. Ray Dalio: Mm-hmm. ES: With the US, the UK, Japan in the middle, as the global imbalance. If something doesn't give, what happens? Ray Dalio: Well, we know how the machine works. OK. If we all agree on how the machine works; if you continue to maintain those imbalances then what's going to happen is the creditors build bigger portfolios of those assets. Those are liabilities; they begin to know that those are bad liabilities. I don't want to have those things. ES: Mm-hmm. Ray Dalio: So this has happened through all deleveragings. The nature of capitalism, the nature of what's held starts to change. Something like the Chinese (rather than on the margin) or others, Middle Easterners or others, creditors, or even ourselves on the margin, choose not to want to make those loans. That they said, 'I'd rather hold other kinds of assets,' and portfolio mixes change, currency mixes change, and so on. As those things change then they have an effect. So for example, if there's less buying of long-term treasuries, and that becomes normally the path, then it is normal (this happens all the time), then the central bank will make purchases of long-term treasuries to make that difference. That doesn't mean necessarily inflation because you're dealing with a deflationary environment. It's a monetization of debt. OK, lo and behold, we're monetizing debts in various ways. That has a certain dynamic that then changes what those portfolios are, and then it causes, you know, a market
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adjustments. Naturally, governments don't want those market adjustments; naturally they try to intervene. As they intervene, they have so we have to eventually work our way toward equilibrium. Meaning, that the price at which we're exchanging goods and services at is sensible; that we're going to be competitive, that you have to be productive, or whatever, you've got to earn it. You can't continue to maintain those imbalances, and prices will change. ES: We want to get in a question or tow but I want to ask you first, because I know that this is an answer that everybody is looking for. Lots of macro managers make the case for an economic framework. Lots of them aren't doing so well; Bridgewater is doing well. What's working now? What has worked for you this year? Ray Dalio: Well I think, the biggest thing, like I said, and there's 15 uncorrelated things I think that again, I can answer this at two levels. I'm going to answer it on the higher level, which I think is the more important level. I constantly know that I don't know. And, you know, the main reason I write the daily observations is we want to communicate well with clients and so on, but the main reason is because I want to know where I'm wrong. So lots of times if somebody points something out it helps me, and I want to have a diversified bet of uncorrelated bets. If I'm doing well it's not because you're going to name the one of two things that I pick great, because you won't do well over a long period of time by doing that you're playing Russian Roulette, the day is going to come that you're going to be wrong. If you do it in a way where you really do have quality, diversification, and a whole bunch of things where you've got an edge on, so you're playing the role of the casino rather the gambler in the casino, that's how you're going to make money I believe. Some years are better than others. When I say some years are better than others, this year and last year were better than I expect. You know, we've had bigger than normal numbers. We expect something like that 15% a year not to lose money. I think our, we don't want to lose money 15% a year. And then you get better and worse, but you have to have that. My
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good year is basically because a number of bets have come well, not because one thing has come well. ES: I know we could go on; unfortunately we can't. Ray, I'd like to thank you. Ray Dalio! Ray Dalio: Thank you, Eric ###End Transcript### Thoughtful Capital Group is a Greenwich based advisory consultancy focused on helping hedge funds and instituational asset managers better understand risk and allocation using systems thinking approaches. The Thoughtful Capital Group is in no way associated with Bloomberg or Bridgewater Associates but we like their style.

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