Ray Dalio breaks down his "Holy Grail"

the real question for me was what would the marginal benefits of diversification like how would you know what is that going to look like ok and what I then decided to do was to think about word risk and the number of sample size and the correlation of the bets broke it down to its each of its components right so to use an example let's assume you have make it simple a return something that has a 10% risk we'll call risk standard deviation and let's make it simple and let's say it had a 10% return and let's say I add in another asset another return asset return stream I add in a second a third a fourth of fifth up to whatever number how would that reduce my risk if it on average has a 60% correlation or if it has on average has a 40% correlation or a zero percent correlation how would that change wanted to know that right so that's what this chart shows right and so hmm so imagine you have a 10% average return you don't know which bet is going to be better has a 10% average return and a 10% risk and you add in a second and a third and so on you're not going to lose the 10% because you're still going to have that 10 percent return but you're going to then have a reduction and that's the reduction in risk and if it has a 60% correlation and you have three or four you will get a reduction that maybe is about 15% and you could add in a thousand if there's 60% correlated and you're not going to reduce your risk much okay that's important now if I look at that how that changes according to the levels of the correlation I start to think well what would happen if I added in something that had a 10% correlation by way of example okay now that's what that line shows okay and it shows how much okay at about 7 or 8 or so I cut my risk in half that means I've doubled my return relative to my risk right oh that's good so as I go down this I then start to understand what the power of diversification is in terms of the things that I'm going to look for so what that taught me is the magic is in only you only need to do this simple thing the simple thing is to find 15 or 20 good uncorrelated return streams things that are probably gonna make money but you don't know but they have a good probability making money and that but you have that are uncorrelated that have low correlation that told me that's what I have to go after right that's the key a lot of people think that the most important thing you could do is find the invest investments okay that's important okay but there is no great one best investment that can compete with something like this so look at this line when this comes down you can improve your return to risk ratio by a factor of five by five times the expected return for that unit of risk you can't pick any investments that it probably nobody's humanly capable in an efficient market probably to pick investments that are five times as good individually but so that bad so it tells me about the power of diversification and balancing risk so this is the return to risk ratio that happens for each one of those you know like if I can get zero correlation and I have 15 to 20 I'll have an information ratio a return to risk ratio of 1.25 that means my probability of losing money in a year is only 11% okay as this thing from 40% with any one of us so that's the power of portfolio construction and the power of diversification okay so it tells me what I have to go after [Music]

Channel: Investopedia

Views: 1,168,971

Keywords: investopedia, investing, finance

Id: Nu4lHaSh7D4

Length: 4min 43sec (283 seconds)

Published: Sat Apr 27 2019