Ray Dalio: Diversification is NOT for Idiots

you're more diversified when i look at the way you set up your portfolio it's not as niche as that uh i'm big on diversity you're very big on diversification knowing how knowing how to adversify well is more important than almost anything people don't understand this is that an evergreen principle yes that's an evergreen principle interesting and the reason i'm saying that the way it is it's almost like a casino making its money okay okay the way that you do it is you get an edge so now when you have to make a bet i've got to bet against the whole world the world has view on something is reflected in the price so when i think something is attractive or unattractive that means i have to bet against the whole world and whether that's right or not that's difficult i get it right you know more often than i get it wrong but i'm going to get it wrong sometimes and so when you can take a lot of different bets what you can do is like the casino you'll get your average that your bet would be but you'll reduce your risk of one of those tables not being the table that's paying off and so that margin then so i can reduce my risk without reducing my return by knowing how to diversify and i'd say that's particularly true important for for the people who are listening you're investors because what they've got to reduce risk without reducing return that's right that's the specialty that's right elaborate a little bit more if you don't mind on that so reducing risk without reducing the return because a lot of times if i'm reducing the risk it means my return is also going lower but you're saying no we're reducing it without even reducing the return right i mean that's a high paying skill set to have it's the most important thing that you could start off doing if you have a number of equally good likely vets but they're uncorrelated like the casino you know one table is going to get me a margin like this but take another table and it makes me a margin like this but i might have volatility about those let me take all those investments that i think will make 10 so that's my return but they're uncorrelated with each other that means i'll still get to 10 i don't lower my 10 but my diversification means i lower my risk so i improve my return to risk ratio ah is that an art that you can teach oh yeah yeah i wrote about it in there's a what i call a section in this book the holy grail of investing it's like three pages long and it explains basically this important thing because when that epiphany happened to me and how i would do it it changed everything by being able to do that because i can improve through diversification i can improve my return to risk ratio by a factor of five so by diversifying okay the return relative to the risk i can keep my returns the same and reduce my risk to one if i know how to diversify well and that's why i'm explaining it's not all that complicated it's simply explained in the book but in any case that is the holy grail of investing okay that's a big thing if you start to know that that's what you're going for it changes everything the real question for me was what were the marginal benefits of diversification like how it you know what is that going to look like okay and what i then decided to do was to think about risk and the number of sample size and the correlation of the bets broke it down to each of its components right so to use an example let's assume you have to make it simple a return something that has a ten percent risk we'll call risk standard deviation and let's make it simple and let's say it had a 10 percent return and let's say i add in another asset another return asset return stream i add in a second a third a fourth a fifth up to whatever number how would that reduce my risk if it on average has a 60 correlation or if it has an 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 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 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 percent and you could add in a thousand if they're sixty percent 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 seven or eight 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 isn't 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 going to make money but you don't know but they have a good probability of 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 best 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 right five times the expected return for that unit of risk you can't pick any investments that are probably always humanly capable in an efficient market probably to pick investments that are five times as good individually but so that path 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 percent okay as this thing from 40 percent 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 you

Channel: Investor Talk

Views: 54,290

Keywords: Investing, Investments, Finance, Wall Street, ETF, Stock Market, Warren Buffett, Economy, Long Term, Bonds, Bitcoin, Portfolio

Id: kHWSbmAyFLM

Length: 8min 0sec (480 seconds)

Published: Fri May 15 2020