Over the weekend I came across some excellent investing counsel from hedge fund titan Ray Dalio in the book The Global-Investor Book of Investing Rules by Philip Jenks and Stephen Eckett. Although not known as a “value investor” in the classic sense of the phrase, Dalio’s approach is solidly grounded in value investing principles. Per Wikipedia, “Ray Dalio is an American businessman and hedge fund manager who in 1975 founded Bridgewater Associates which manages approximately $80 billion in assets. As of 2007, his net worth was estimated at $4.0 billion.”
Here is a quote from the The Global-Investor Book of Investing Rules.
There are some general principles that most winners of this game employ that losers neglect. If you want to win any game, you must know what the principles of the game are, and then work to develop the required skills – e.g. counting the cards and calculating odds for poker. What I describe here is my approach to playing the game, which is a mix of these general principles and my own twists on them. For me, the following are required.
1. A deep understanding of the fundamentals so that pricing inefficiencies can be identified.
Adding value (getting a return greater than that available from passive investing) requires one to see how markets are mispriced, and this requires an understanding of how they should be priced. This is required to be a winner over time. It is the equivalent of being able to count cards and calculate the odds of a winning hand in poker – it is the fundamental assessment that allows you to discern a good bet from a bad one.
Some people say that understanding the fundamentals isn’t required and that one can play and win the game by playing it technically. If by technical they mean an approach that is devoid of understanding fundamental cause-effect relationships – like trend following – then I believe that they are wrong. Sometimes markets trend, and sometimes they chop, and they do so for reams. So, without an understanding of these reasons, one will be blindly betting that markets trend more than they chop. Do markets trend more than they chop? This is one of thus cosmic questions that can’t be definitely answered, and certainly not without an understanding of the fundamentals that determine marks behavior.
There is no escaping the need to have a deep understanding of the fundamentals so that one can sensibly assess what is cheap and what is expensive. In playing poker, I would rather place my bet based on my ability to count the cards and calculate odds than on the likelihood of hot streak continuing (e.g. betting that I will do well because I won the last few hands).
Adding value is a zero-sum game – for me to add value I must be a better player than my opponents. The markets are extremely competitive. That means that my understanding must be very deep, which requires focus. I have rarely seen investors that win over time who trade a lot of different markets. The winners I know discuss their markets with the same depth that specialists in other professions (e.g. physicians, scientists, etc.) discuss the subjects of their focus [emphasis added].
In addition, successful market players have the capacity to think conceptually and independently. Equipped with knowledge and perspective, they can justifiably have the confidence to stand apart from the crowd, which is essential for being able to buy low and sell high.
3. Perspective without data-mining.
Many years ago I did a lot of discretionary trading based on the flow of information I was seeing at the time. I wrote down the criteria I used to make each trade so that I could reflect on the trade later. I learned that if I specified the criteria clearly I could see how these criteria would have worked in the past, and in different countries, which gave me perspective. That perspective was invaluable.
In many cases I learned that the criteria wouldn’t have worked in the past and I could see why. In other cases I learned how well my decision rule worked so that I would not abandon it when it lost (all rules lose sometime) or put too much on it because it has recently been hot and I thought it was better than it really was. As a result, I developed a good sense of what I could expect from my criteria.
I learned that I could program the computer to scan the world for opportunities, according to these criteria. And I learned a lot more. I learned to be especially wary about data mining – to not go looking for what would have worked in the past, which will lead me to have an incorrect perspective. [Greg Speicher’s note: “If past history was all there was to the game, the richest people would be librarians. – Warren Buffett] Having a sound fundamental basis for making a trade, and an excellent perspective concerning what to expect from that trade, are the building blocks that have to be combined into a strategy.
Knowing how to identify good bets is only the first step. Knowing how to balance these bets – how much to place to on each based on their different expected returns, risks and correlations – is at least as important. This requires an understanding of probabilities, statistics, and money management principles. It requires the ability to simulate how this strategy would have worked in the past and to stress test its performance under varying conditions.
5. Substantial resources.
The days that an astute individual trader equipped with little more that his wits, being able to be a substantial winner at this game are over. Now, world class teams consisting of conceptual thinkers supported by specialists and advanced technology set the standard of play. While technology has radically advanced the average level of play, in markets as in warfare, it has served to widen the gap between the resource-rich and the resource-constrained players.
Ray Dalio’s Principles – Here’s a brief expert of how he learned his craft [my emphasis added]:
2) I came up with the best independent opinions I could muster to get what I wanted. For example, when I wanted to make money in the markets, I knew that I had to learn about companies to assess the attractiveness of their stocks. At the time, Fortune magazine had a little tear-out coupon that you could mail in to get the annual reports of any companies on the Fortune 500, for free. So I ordered all the annual reports and worked my way through the most interesting ones and formed opinions about which companies were exciting.
3) I stress-tested my opinions by having the smartest people I could find challenge them so I could find out where I was wrong. I never cared much about others’ conclusions–only for the reasoning that led to these conclusions. That reasoning had to make sense to me. Through this process, I improved my chances of being right, and I learned a lot from a lot of great people.
4) I remained wary about being overconfident and I figured out how to effectively deal with my not knowing. I dealt with my not knowing by either continuing to gather information until I reached the point that I could be confident or by eliminating my exposure to the risks of not knowing.
Recession? No, It’s a D-process, and It Will Be Long – 2009 Barron’s interview
Inside the world’s biggest hedge fund – Fortune, March 19, 2009
Books from the Fortune article:
Essays on the Great Depression by Ben Bernanke
The Great Crash of 1929 by John Kenneth Galbraith
Dalio’s recent appearance on CNBC