Risk Latte - On Ray Dalio and the Zen of Trading

On Ray Dalio and the Zen of Trading

Aditya Rana
June 05, 2010

Ray Dalio, the chief investment officer of Bridgewater associates’ which manages $75 billion of assets and has had an outstanding performance record over the years, shares his thoughts on financial markets in a recent interview. it is rare to come across Dalio’s views in the financial media , and is important to listen closely to what he has to say:

  • The unprecedented stimulus provided by governments across the globe has allowed the stock market to retrace 60% of its decline and the U.S. economy to retrace about 40% of its decline. But it has not created much new lending and very little economic activity.

  • The boundaries of the old highs and the March ’09 lows are likely to stay for a long while as governments have shown clear determination to prevent a collapse and they will print money again as required.

  • However, the big risk is that sometime before 2012 (and earlier than what most people expect) the economy is likely to dip into a recession again and the growing negative perception may constraint the government’s ability to stimulate aggressively.

  • The debt burden has not been reduced in any significant way - it has just been rolled over to the vicinity if 2012 to 2014 – so a move up to the old high is unlikely for a while.

  • The European debt crisis dwarfs all previous sovereign debt crises - the Latin American crisis and the Asian contagion. The government debt of the peripheral European countries which needs to be rolled over in the next three years is $1.9 trillion – and that doesn’t include private debt which is also huge.

  • Europe will therefore undergo a painful decade of adjustment – much like what happened in Latin America and Japan.

  • The emerging markets are roaring ahead as they have not reached debt capacity limits and have cheap labour and high levels of investment. And they (china) are unable to tighten monetary policy as their currencies are linked to the U.S. dollar.

  • However, a process of tightening is inevitable – mainly through other means like raising reserve requirements and controlling credit growth.

  • U.S. - China relations are likely to deteriorate with trade and currency disputes and rising protectionism in the U.S. and Chinese threats on capital flows.

  • Their portfolio is skewed towards treasury bonds, gold, emerging market (especially Asian) currencies – and they are minimizing exposure to the currencies of the developed world as they will continue to print more money and have sluggish growth rates.

  • However, depreciation of currencies and printing of money is unlikely to create any meaningful inflation anytime soon – as the deflationary forces arising from weak demand and credit growth, and excess capacity in manufacturing, labour and housing will continue to prevail for a while.

  • So government bonds in countries which are able to print money will provide good investment opportunities.

Dalio provides a great snap-shot of the key issues the global economy and markets are grappling with and what i have continuously referred to in previous emails. Government actions are likely to continue to put a floor to the market’s downside for a few years – while rallies will be somewhat muted because of the debt overhang. range trading market will provide ample investment opportunities to take advantage of temporarily oversold (and overbought) market conditions – both tactical (short term buying opportunities like prevailing currently?) and strategic (long term positions when markets get oversold as well as undervalued-perhaps later this year?). the periodic bailing-out of the market (and economy) by governments will eventually make the debt burden untenable leading to a developed world sovereign debt crisis in the form of devaluations, inflation and restructuring. to help you navigate the volatile markets over the next few years I ask you to ruminate on this selection of rules from Barry Ritzholz -the “Zen of investing/trading”

1.have a comprehensive plan: whether you are an investor or active trader, you must have a plan. Too many investors have no strategy at all — they merely react to each twitch of the market on the fly.

2. expect to be wrong: this is such a key aspect of successful investing that it bears repeating. You will be wrong, you will be wrong often and, occasionally, you will be spectacularly wrong. Michael Jordan has a fabulous perspective on the subject: “I’ve missed more than 9,000 shots in my career. I’ve lost almost 300 games. twenty six times, I’ve been trusted to take the game-winning shot and missed. I’ve failed over and over and over again in my life. And that is why i succeed.”

The best investors have no ego tied up in a trade. those who refuse to recognize the simple truism of “being wrong often” end up giving away unacceptable amounts of capital. Stubborn pride and lack of risk management allow egotists to stay in stocks down 30%, 40% or 50% — or worse.

3. predetermine stops before opening any position: sign a “prenuptial agreement” with every stock you participate in: when it hits some point you have determined before you purchased it, that’s it, you’re out, end of story. once you have come to understand that you will be frequently wrong, it becomes much easier to use stop-losses and sell targets.

4. follow discipline religiously: the greatest rules in the world are worthless if you do not have the personal discipline to see them through. I can recall every single time i broke a trading rule of my own, and it invariably cost me money. In Jack Schwager’s seminal book market wizards, the single most important theme repeated by each of the wizards was the importance of discipline.

5. keep your emotion in check: emotion is the enemy of investors, and that’s why you must have a methodology that relies on objective data points, and not gut instinct. the purpose of rules 1, 2 and 3 is to eliminate the impact of the natural human response to stress — fear and panic — and to avoid the flip side of the coin — greed.

6. change is constant: Heraclites was a Greek philosopher best known for his “doctrine of flux”: “the only constant is change.” that doctrine is especially true in the markets. Therefore, as you constantly upgrade your skills, you must remain supple enough to adapt to an ever-changing field of play.

7. understand sector strength and market trend: studies have convincingly demonstrated that about 30% of a stock’s progress is determined by the company itself; a stock’s sector is equal to at least another 30% (if not more). the overall direction of the market is an even bigger factor, counting for some 40%. (As I have emphasised numerous times previously- asset allocation is key!)

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