All Weather - Ray Dalio's Approach to the Ultimate Investment Case Study

Morning Monkeys,

Many seasoned veterans of WSO will recognize a common thread posted by many prospective monkeys, "Help Me Solve This Case Study," where a prospective candidate will outline a given case study and their attempts for a solution. As many of us know, these case studies can give a potential employer insight into the thought process of the candidate but, the reality is, no candidate has ever been given a real life investment problem that a firm needs solved. Thankfully, Bridgewater Associates has recently released a report on the construction of their All Weather strategy, giving us an insight into the thought process of an industry titan, Ray Dalio, when solving a real life investment problem.

I urge everyone to read the report in its entirety, as it contains far more than just the thought process used in constructing the All Weather strategy. However, for this post, we'll stick to the discussion of the thought process itself in hopes that an aspiring monkey will find it useful.

The process began when Ray Dalio and CIO Bob Prince, among others, explored a deceptively straight-forward question:

What kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?

While this may appear as a simple question, it is certainly not one with a simple answer. The report goes on the discuss the process by which Dalio and other Bridgewater Associates arrived at the answer, detailing their foray into liability management, at the time an underserved market. After a long education process, Dalio and others would write a "Risk Management Plan" to convey the value of liability management to corporate treasurers.

Ray, Bob and others would write a “Risk Management Plan.” These were tailored analyses that generally followed three steps; a) identify the risk neutral position for the corporation b) design a hedging program to reach that exposure and c) actively manage around that exposure, hiring Bridgewater and paying them based on performance around this neutral position. Over time this approach had Ray, Bob and others managing $700 million in corporate liabilities.

This particular style of thinking wasn't limited to liabilities, and the transition to assets followed the same style of thinking:

Bridgewater approached the [World Bank pension fund] asset portfolio in the same way. The bond benchmark was the risk neutral position; the active management was the value added, or alpha, gained from deviating from the benchmark. The two are completely separate.

This is a very important point, as it breaks down the thousands and thousands of investment products into three component parts:

The reality is that the return of that product, or any product, is a function of a) the return on cash b) the excess return of a market (beta) above the cash rate and c) the ‘tilts’ or manager stock selection (alpha).

Or, more simply:

RETURN = CASH + BETA + ALPHA

The next step in the thought process that would eventually form the basis for All Weather are the ideas of environmental bias and risk balancing assets. The former was initially fleshed out while Bridgewater was providing advice to Rusty Olson, the CIO of a large US-based consumer goods manufacturer, on the composition of the pension fund:

The 1990 memo to Rusty put it this way, “Bonds will perform best during times of disinflationary recession, stocks will perform best during periods of … growth, and cash will be the most attractive when money is tight.” Translation: all asset classes have environmental biases. They do well in certain environments and poorly in others. As a result, owning the traditional, equity heavy portfolio is akin to taking a huge bet on stocks and, at a more fundamental level, that growth will be above expectations.

The latter concept of risk balancing assets began much earlier during Bridgewater's time helping corporations hedge unwanted balance sheet exposures. Dalio and others at Bridgewater always considered risk first, and during their time with Rusty Olsen, this commitment to risk as first and foremost remained:

Due to his equity holdings Rusty was exposed to the risk that growth in the economy would be less than discounted by the market. To 'hedge' this risk, the equities needed to be paired with another asset class that also had a positive expected return (i.e. a beta) but would rise when equities fell and do so in a roughly similar magnitude to the decline in the stocks. The Bridgewater memo agreed that Rusty should hedge this risk with long duration bonds that would have roughly the same risk as his stocks. Quoting from the study: “low-risk/low-return assets can be converted into high-risk/high-return assets.” Translation: when viewed in terms of return per unit of risk, all assets are more or less the same. Investing in bonds, when risk-adjusted to stock-like risk, didn’t require an investor to sacrifice return in the service of diversification.

Over time these two concepts formed the beginning of what would eventually become All Weather, however, an important insight was remaining:

A key step was framing growth and inflation as the environmental drivers that mattered and mapping asset classes to these environments.

At this point in Bridgewater's history, Dalio and others who lived through the 1970s were very familiar with inflationary environments, not to mention the disinflationary environment of the 1980s. They knew that commodities performed best in an inflationary environment, but how to bring this notion into use required a simple experiment:

Bob was fiddling around with a new computer program, Microsoft Excel. Microsoft had released the first windows based version of it in 1987. With these tools Bob began playing around to see how shifting asset weights would impact portfolio returns. He found that the best performing portfolio was 'balanced' to inflation surprises. This made some sense coming after the inflationary 1970s and the dis-inflationary 1980s. It also held true for more extreme shocks, like the 1920s German hyperinflation or the US Depression. Bob shared his discovery with Ray. “I showed it to Ray and he goes, ‘that makes sense,’” Bob recalled years later. “Then he goes, ‘But it really should go beyond that, it should really also be balanced to growth.’”

So, while the data initially developed by Bob during his experiment indicated that assets should be balance by inflation sensitivities alone, Dalio knew that this couldn't be the whole story, that his common sense told him something else. From here, a diagram that tied the principles together was developed, which soon became a template for All Weather:

Much as a portfolio can be boiled down to three key drivers, economic scenarios can be broken down to four. There are all sorts of surprises in markets, but the general pattern of surprises follows this framework, because the value of any investment is primarily determined by the volume of economic activity (growth) and its pricing (inflation). Surprises impact markets due to changes in one or both of those factors. Think about any stress scenario and it ends up putting a portfolio in one or two of these sectors unexpectedly. The 1970’s oil shocks, the disinflation of the 1980’s or the growth disappointments post 2000 were all shifts in the environment relative to expectations. This framework captured them all. More importantly, it captured future, yet unknown surprises.

At the time this framework was used by Bridgewater to explain their work to prospective clients. Since most Bridgewater personnel was focused on alpha, the work done refining and articulating tactics and decisions making rules stemming from this early work led to a key tactical strategy being released in 1991: Pure Alpha.

There was still a major ingredient missing: inflation-linked bonds. The concept of such a security wasn't new, but in the early 1990s, they weren't very common. How to deal with this seemingly missing piece was discovered along the way, while dealing with a foundation interested in achieving a 5% real return, whose problem was approached in the same rigorous manner, by:

Going back to the building blocks of a given portfolio, the client’s “risk-free position” was no longer cash, but rather a portfolio that provided a real return. Inflation-linked bonds, bonds that pay out some real return plus actual inflation, would ‘guarantee’ this 5% hurdle, as long as one could find bonds paying 5% real coupons. The main problem, however, was that there weren’t any of these bonds in the US at the time. They were issued widely in the UK, Australia, Canada and a few other countries. As currency and bond managers, Ray, Bob and Dan knew how to hedge a bond portfolio back to dollars, eliminating the currency impact. The three of them sought to construct a global inflation-linked bond portfolio and hedge it back to the US dollar as a solution for the endowment. At the time, global real yields were around 4% so a little bit of leverage had to be applied to the inflation linked bonds to reach the endowment’s target.

In 1996, All Weather emerged fully formed, and the ultimate asset allocation map was finally developed:

Ray described creating the portfolio “like inventing a plane that’s never flown before.” It looked right, but would it fly? He started running a pilot with his assets, and it was someone’s part-time job to rebalance the portfolio from time to time. The portfolio flew the way Bridgewater expected, but it remained purely for Ray’s trusts. All Weather was never envisaged as a product. It was profound enough that no one was doing it but at the same time so straightforward that anyone could seemingly do it for themselves.

All Weather started out as a strategy for Dalio's trusts, but after the tech bubble popped in 2001 - showing that equities were not as safe as they appeared - coupled with the financial meltdown of 2008, many investors were ready for an alternative and a new way of thinking.

Gradually objections surrounding All Weather eased. As investors grew accustomed to looking at leverage in a less black-and-white way – “no leverage is good and any leverage is bad” – many have come to understand that a moderately-levered, highly-diversified portfolio is less risky than an unleveraged, un-diversified portfolio.

Hopefully this has given everyone a new way to look at a case study (as well as their portfolios). Dalio's thought process shouldn't be a surprise in its approach: Seperate the problem into its component parts, determine what specific risks and influences affect the component parts, and construct your solution guided by logic and common sense (i.e. don't let data trump the obvious). And hopefully, the application of this process, as demonstrated in the report, has been helpful in clearing up some misconceptions.

I would urge everyone to read the report in its entirety as I'm sure I haven't done it the justice it deserves. Some of these concepts won't be surprising to some, but I found it to be very illuminating. To close this post, let's remember what All Weather, and it's brilliant capacity to sketch a strategy on the back of a bar napkin, was designed for, and ergo, the case it solved:

All Weather grew out of Bridgewater’s effort to make sense of the world, to hold the portfolio today that will do reasonably well 20 years from now even if no one can predict what form of growth and inflation will prevail. When investing over the long run, all you can have confidence in is that (1) holding assets should provide a
return above cash, and (2) asset volatility will be largely driven by how economic conditions unfold relative to current expectations (as well as how these expectations change). That’s it.