🟢 What I learned managing $210 billion

You'll be better at investing than 99% of the world with these principles

(10 min read)

Of course my role at the #1 hedge fund in the world was minuscule in comparison to my coworkers’.

There were ~100 of us working together managing investments for our institutional clients.

(Almost everyone else was more important than I was.)¹

Still, it was life-changing to work with billionaire Ray Dalio, Bob Prince, and Greg Jensen other folks.

To be roommates with Karen Karniol-Tambour (now Co-Chief Investment Officer) for 4 years.

To play basketball every week with brilliant investment strategists and system-builders.

To be trained and trusted by them to produce world-class investment help for the largest portfolios in the world.²

I quickly realized that I now knew more than 99% of the world about investing.

I titled this post to catch your eye because:

You can benefit from the lessons I learned working with legendary investors at the #1 hedge fund in the world.

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Today we’ll learn:

1) Where returns actually come from (and why the distinction matters)

2) The risk almost everyone forgets about

3) Overlooked results of diversification

4) The best deal for individual investors

5) “The holy grail of investing” according to Ray Dalio

⚠️ Warning: By the end, you’ll have a serious mistrust of most financial advisors.

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1) Where returns actually come from (and why the distinction matters)

(“Return on investment” or ROI is just a way of saying “profit”.)

Many financial advisors, mutual funds, etc are incentivized to mislead you.

They charge high fees for their so-called talent at predicting how markets will behave (i.e. making good bets for you).

For example, a mutual fund might advertise itself in a way that brags about its past performance, as if the managers of that fund did a great job in predicting the market and making smart trades that earned the fund lot of money.

But how much of that past performance came from their skill, really?

How much was instead a result of overall market trends?

Wouldn’t you want to avoid paying high fees to a mutual fund if its performance is mostly something you could replicate yourself just by buying and holding index funds passively?

You need to separate in your mind the reasons that someone can expect to earn a return for an investment.

Returns come from:

Savings interest rate
+
how much more you could earn passively via diversified index fund investments over long time-frames (decades)
+
how much you could earn outsmarting the world’s smartest investors (unlikely)

(At Bridgewater, we labeled these 3 components “Risk-free rate” + “beta” + “alpha”.)³

Why is it important to think of these concepts separately?

Not knowing the actual factors that lead to profits would be like trying to play basketball without knowing where the hoop is or what rules lead certain shots to count 1, 2, or 3 points.

Mutual funds (as distinct from passive index funds) tend to claim to be alpha (and therefore charge high fees) when in reality:

1) most of the performance of the mutual fund comes from beta

and

2) passive index funds historically have outperformed active funds anyway

Risk-free rate

When you deposit cash into a savings account, you’ll earn interest.

You’re temporarily parting with your cash now with the expectation that you’ll receive more cash later.

Investors demand compensation for parting with their money for a period of time (i.e. the “time value of money”).

Although the interest rate will be meager, it’s guaranteed.

In the US, even if the particular bank fails, your savings will be unharmed because the government’s FDIC provides insurance.

This interest is considered the “risk-free rate”.⁴

Beta⁵

This represents the additional “risk premium” baked into the price of an asset.

As an investor, if you want to earn more than the meager interest rate that a savings account provides, you need to take some risk.

The simplest example:

If you make a loan (which is essentially what you’re doing if you buy a bond), there is a risk that the borrower won’t repay you.

Given this risk, why would you ever make a loan (or buy a bond)?

Because the borrower will provide extra compensation for this risk (beyond the risk-free rate, which merely compensated you for the “time value of money”).

If you hold a diversified collection of many assets, then the collection the risk premiums generated by each of those assets will likely outweigh the losses from the handful of cases where an asset loses money (such as when a borrower fails to repay a loan).

In other words, passively holding a diversified collection of assets for a very long time can be a great strategy (as long as you believe capitalism will prevail in the long run).

Alpha

“Alpha” = excess returns generated by skill.

What insights do you have that others don’t?

But watch out—“insider trading” is illegal.

So your insights must come from data that is publicly available.

How can you predict movements of the markets and time your trades appropriately?

The returns you earn from this skill is what we called “alpha”.

Alpha is the most competitive game on the planet.

You (as an individual) will almost certainly lose.

Bridgewater and other similar hedge funds collect unimaginably vast amounts of data.

Their data centers consume more energy than entire countries.

Seeing this, I decided that the alpha portion of my personal portfolio should be nearly 0%.

If you think gambling is stupid and irresponsible, you probably would agree that trying to outsmart the world’s smartest, best-equipped investors is pretty reckless.

In other words, unless you think you’re as smart as teams led by Warren Buffett, Ray Dalio, Peter Lynch, or Carl Icahn:

Don’t pick individual stocks or bonds or other assets. Don’t try to time the market.

Other than your savings account, you should buy only passive index funds (a diversified mix of them) and hold them as long as you can.

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🙌 Do you want to get featured in a future issue? Let me know.

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2) The risk almost everyone forgets about

The way everyone thinks about asset allocation is wrong.

You’ve heard the recommendation:

“Hold 60% of your portfolio in stocks and 40% in bonds.

It’s not as risky as holding only stocks, but it will still profit a lot.”

Let’s explore why your parents or financial advisors probably recommended this (and how I recommend adjusting your thinking).

Stocks have tended to generate annual returns from -40% to +50%.

Over long enough time periods, the average annual return has been probably around 6 to 10%.

But you’ve noticed that some years the returns have been negative 40%.

You know how painful that is? At such a time, you might feel like your life was ruined.

(Go look at your accounts now, and imagine the numbers quickly decreased by 40%. What emotions come up?)

Bonds have produced a lower average annual return but have experienced less volatility (fewer periods of losses).

So, it is likely true that a portfolio with some bonds will have more stable performance (although lower overall returns, on average) than a portfolio that holds only stocks.

However…

Most people miss this fact:

The economic factors that lead stocks to perform well will have an outsize impact on your portfolio compared to the factors that lead bonds to perform well.

For simplicity, let’s consider a portfolio that were split evenly, 50% stocks and 50% bonds.

Because stocks are more volatile than bonds, the portfolio’s performance will perform like it is almost all stocks.

In other words, the 50/50 or 60/40 portfolio was not as diversified as you thought it was.

When constructing your portfolio, you should think more about how you allocate risk rather than dollars.

What you actually want is a portfolio that aims to be agnostic of market surprises.

The idea is this:

If you admit that you are not personally capable of outsmarting the world’s most successful investors (i.e. you can’t confidently predict exactly when the market will go up or down), you should resign to collecting risk premiums from a diversified collection of index funds held passively over the long term.

Bridgewater came up with an allocation of passively-held index funds (they call this strategy “All Weather”) that ought to perform well (collect risk premiums) regardless of whether there was more or less inflation than the market predicted and regardless of whether there was more or less growth than the market predicted.

I won’t go into detail here, but it involves holding index funds of inflation-linked bonds, nominal (regular) bonds, commodities, stocks, etc.

Let me know if you’d be interested to talk more about All Weather.

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3) Overlooked results of diversification

It took me an embarrassingly long time to understand:

Wealth gets created and destroyed via concentration and preserved via diversification.

I’ll say it again because it’s important.

Taking big bets is how you can quickly change your net worth, while taking many small bets is how you keep it more stable.

Passively holding diversified index funds over the long term is a great way to preserve your wealth (and slowly grow it).

If you take bigger risks, you can experience much bigger gains or crashes.

Let’s pretend you have $100k on hand.

You could buy $100k of a single stock (such as AMZN), which in a way is like “betting it all on black at a casino”.

You’re not in control of the outcome.

The $100k might disappear (if AMZN crashes).

On the flip side, if AMZN performs much better than the market expected, you have unlimited upside potential and could profit millions of dollars.

Let’s look at an alternative.

Maybe instead you choose to invest all of the $100k in 5 to 10 index funds (which each hold dozens of assets) diversified across asset classes (stocks, bonds, inflation-linked bonds, commodities, etc) and geography (US, Europe, Asia, etc).

In that case, it would be highly unlikely that you’d ever lose all $100k in a crash.

But it would also be nearly impossible to profit millions from that portfolio (since its annual return will probably be only 5-10%).

Let’s recap the first 3 lessons.

Lesson 1 showed us that non-experts should focus just on savings accounts + diversified index funds held passively for the long-term.

Lesson 2 showed us that we can carefully allocate different amounts of money to different index funds in an attempt to make the overall portfolio agnostic of market environments (so that it performs decently no matter what the conditions are).

Lesson 3 says that diversification preserves wealth while concentration is what creates or destroys it.

My personal approach (given these lessons) is:

1. Put tens of thousands of dollars in savings accounts. This money is immediately available if I need.

2. Invest almost 100% of the rest of our money in diversified index funds (prioritizing tax-advantaged accounts like 401Ks or IRAs). The asset allocation mimics All Weather. Compounding over time is our friend.

3. Only invest money in a concentrated way when I can influence the outcome (e.g. in my own business).

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4) The best deal for individual investors

Collateralized loans (such as mortgages or car loans) often charge less in interest than you can expect to earn from your diversified portfolio of index funds.

(E.g. 5% mortgage vs 6-10% returns from an All Weather strategy.)

Therefore, even if you can afford to pay cash for a house, don’t.

Get a mortgage.

Leave your money invested.

This is a form of leverage.

I remember when I was buying my first car (a pre-owned blue 2003 Acura TL, which I loved).

0% interest loans were available (because of how weird the economy was at the time).

I could afford to pay cash for the car, but I chose the loan.

My money stayed invested and probably earned me 10% per year while I paid off the car (with 0% interest).

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5) “The holy grail of investing” according to Ray Dalio

Feel free to skip this section.

I included this section just to be thorough, but you and I are mere mortals who will never compete with the world’s most powerful hedge funds.

Please don’t be overconfident.

Imagine what Albert Einstein felt when he realized E = mc².

That’s what Dalio says he felt when he was doing some research and created a chart that demonstrated the advantages of uncorrelated return streams.

Bridgewater realized that if it could come up with 15-20 ways of outsmarting the market (“sources of alpha”), and if the returns of those bets were 0% correlated to each other, the portfolio would experience massive returns without much volatility.

People often use the word “hedge” to mean waffle, equivocate, or dodge. Or even “offset”.

In the hedge fund world, though, “hedging” = “isolating”.

Hedging means subtracting out exposure (bets that you don’t want to be making) so that you’re isolating one very intentional bet.

Imagine that a hedge fund has analyzed a bunch of data and believes that Airline A will outperform Airline B.

They believe that on a relative basis, Airline A will perform better than Airline B.

But they don’t want to make a prediction about how the overall airline industry will perform.

Simply buying stock in Airline A wouldn’t be a clean bet based on their view, because they don’t have a strong feeling about whether the airline industry as a whole will perform well or poorly.

If suddenly there were a pandemic and the whole airline industry suffered, they would have lost money on their Airline A stock even if they were right that Airline A was superior to B.

Losing money when you’re right means that you didn’t express your prediction properly.

The more responsible way to express their views financially would be to buy and sell various instruments to isolate that bet.

E.g. buy Airline A stock but “sell short” the airline industry as a whole, potentially.

The number of possible alpha return streams (predictions about what can happen in the world) is literally infinite.

But alpha is a zero-sum game, which means you only earn money when you outsmart the market.

As we’ve discussed already, I don’t even recommend trying.

Seeing the inner workings of one of the top financial firms, I was awe-struck by the talent and the resources.

I’d never try to compete against them personally.

A collection of uncorrelated return streams is powerful.

But I wouldn’t recommend trying to discover any in the public markets.

Focus instead on assembling a handful of private businesses that you control whose performance (and dependencies) won’t be correlated with each other.

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What I didn’t learn (about currencies, gold, crypto)

I regret not asking more about gold (when I worked at Bridgewater).

I don’t know why anyone wants to own gold or treats it as an “investment”.

It doesn’t create anything useful or productive, so the only way it becomes more valuable is just if other people believe it’s more valuable.

To me it seems more like a belief-based “bubble”, sort of like currencies are (including cryptocurrencies like Bitcoin).

Bridgewater taught me that currencies don’t provide risk premiums and so are unlike other asset classes.

I.e. trading currencies is the realm of alpha rather than beta. You’d only do it if you felt like you knew more than the others about currencies.

I never understood why Dalio and Bridgewater seem to be fans of gold (which to me seems just like a currency), especially since they have been super skeptical of crypto, which has many of the same properties. I’d be curious to know.

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Conclusion

What Katie and I do financially:

1. We take out collateralized loans when their interest rate is low enough (e.g. 5.5% mortgage, or 0% for 12 months for the house painters).

2. Put tens of thousands of dollars in savings accounts.

3. Invest almost 100% of the rest of our money into diversified index funds mimicking All Weather (prioritizing tax-advantaged accounts like 401Ks or IRAs).

4. Try to never sell and withdraw any funds. As asset prices change (causing deviations from the target allocation), rebalance the All Weather holdings via deposits.

5. Only invest money in a concentrated way when I can influence the outcome (e.g. in my own business).

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🔜 Coming up (Tuesday’s post):

My interview with the guy who tells the truth about 𝕏 and other social media platforms and exposes how people actually attract a following

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💬 Conversation starters:

I'd be curious how you think about managing your investments.

Also, let me know if you’re interested to hear more about this.

E.g. I could get more specific about individual tickers, like VIPSX https://investor.vanguard.com/investment-products/mutual-funds/profile/vipsx.

Reply or leave a comment!

I’ll be so excited to write back to you.

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🕙 What we learned in recent posts:

🟢 Design your work around your ideal life (not the other way around)

🟢 How to be top 1% on Upwork within the first 24 hr of signing up

🟢 Alternative to following some else’s dream

🟢 Impossible ➔ Exceptionally unlikely ➔ Normal

🟢 [See all posts]

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And if you've got a moment, I'd love to hear what you thought of this email.

Send me a quick message — I reply to every email ❤️

1. I was trying not to black out from the pressure of moving money around with more digits than I’d ever seen. 😵

2. There were ~250 people at the whole company, and our total assets under management was ~$145 billion in 2007 USD (inflation = $210 B). Our clients included the largest pension funds, university endowments, and even governments.

3. Bridgewater summarizes these 3 components as: cash rate + market returns + excess returns generated by skilled active management.

4. It’s not 100% risk-free, since even governments can falter (and the US debt is making that more likely).

But it’s as risk-free as you can get.

5. Beware: Various people in finance use this same word differently. I’m only commenting on how we used the term at Bridgewater.