An All-Weather Awakening

Hey everyone,

By popular demand, I’m bringing Chad back!

He's our (fictional) resident crypto degenerate-turned-value investor trying to piece his portfolio back together after losing half his wealth in Dogecoin.

With Chad’s newfound Buffett wisdom from last time, we continue his story in a moment when he is, once again, faced with being overexposed to an asset class.

ChatGPT sets the scene:

Today, we continue broadening our investment horizons through the eyes of Chad. While investing in the stock market is great, Chad is still exposed to potential drawdowns of 30-50%, depending on how bad the crisis may be. Of course, it's better than being down 80% on your ETH bag, but Chad has seen this movie before.

So, determined to learn from his past mistakes, he seeks the guidance of a mentor who's an expert in building truly diversified portfolios.

Enter Ray Dalio

Ray Dalio has achieved near-mythological status as an entrepreneur and investor and has been called the "Steve Jobs" of financial markets.

Dalio founded Bridgewater Associates in 1975 - it's grown to become one of the largest hedge funds in the world, managing over $126 billion in assets.

While there's plenty to dig into within Dalio's book, Principles, Chad's primary focus today will be on one of Bridgewater's essential products - The "All Weather" Portfolio.

Built for any season

Bridgewater's All-Weather portfolio is balanced across various risk exposures and was launched in 1996. Most of its exposure is to bonds with a different structure from most asset managers' traditional stock-dominated portfolios.

The portfolio includes 30% in stocks, 55% in bonds, 7.5% in gold, and 7.5% in commodities. It requires regular rebalancing, meaning when one segment generates returns, a portion of that segment will be sold and reallocated to the original allocation. This is crucial to maintain the benefits of diversification.

This concept is new to Chad, as he's more accustomed to HODLing his altcoin bags all the way down to zero.

The All-Weather Portfolio is based on Dalio's belief that there is a season for everything and was born out of his ability to mine and distil macroeconomic data into meaningful insights.

In an interview with Tony Robbins, Dalio asserts that:

And this is where the premise of the portfolio was formed. According to Dalio, there are only four things that move the price of assets:

• Inflation

• Deflation

• Rising economic growth

• Declining economic growth

And only four different environments, or economic seasons, will ultimately affect whether investments go up or down:

• Higher-than-expected inflation (i.e. rising prices)

• Lower-than-expected inflation (or deflation)

• Higher-than-expected economic growth

• Lower-than-expected economic growth

Dalio teaches Chad that he needs 25% of his risk in these four categories – not 25% of his wealth. This approach always covers each season, so Chad should always be protected. The revelation shocks him since he regularly apes everything he has into his investments.

Certain assets will perform in a particular environment, per the table below.

Chad might look at the rationale for the "All Weather" Portfolio and think it's nonsense. The numbers don't lie, though - since inception, the portfolio has achieved a 7.39% compound annual return, with a 7.14% standard deviation (its risk rating).

Now, I know what you’re thinking - "The All Weather Portfolio returns less than the S&P 500 - why should I even bother?"

Remember that this is a defensive portfolio. So while this portfolio may underperform the stock market when we're in a bull run, it'll outperform in a falling market. And because of this, you should experience smaller drawdowns than having total exposure to stocks.

The portfolio's returns mentioned above are probably skewed, given that the world has just come out of a 13-year bull market, where the All-Weather Portfolio would've underperformed relative to a mooning stock market.

However, the next 5-10 years might be the ideal time for the All-Weather Portfolio, especially if Stanley Druckenmiller's prediction of flat markets for the next decade comes true.

So, let's dive into the critical components of the All Weather Portfolio that we haven’t covered before.

Commodities

While Chad finds this a somewhat obscure asset class - he realises he can purchase them in different ways, such as buying the physical good (like gold bars or coffee beans) or ETFs that track specific commodity indexes.

ETFs, derivative products and other commodity trackers will be more optimal for Chad as he doesn't feel too confident in securing gold bars under his mattress, let alone taking possession of oil barrels.

Remember, we're talking about a guy who, until recently, could hardly keep track of his crypto software wallets.

Commodities are all about supply and demand. The product is essentially the same in any commodity industry - wheat is wheat, and cattle are cattle. As a result, producers are all price-takers.

Imbalances in supply and demand cause prices to fluctuate frequently - this is where an investor like Ray Dalio makes his money. By mapping out cause-and-effect relationships within the world, he's been able to predict where prices of commodities may go in the future depending on a particular set of events that play out.

Investing in commodities requires Chad to understand the supply-demand dynamic. Prices can rise and fall quickly and often do not persist.

If suppliers can reap high prices by increasing production, they'll do so, and eventually, prices will drop to typical levels.

Regarding Dalio's approach to commodities, he advocates for their inclusion in a portfolio as a hedge against inflation. His strategy for commodities includes having a long-term perspective, investing in a broad range of them, and using fundamental and quantitative analysis to make investment decisions.

The factor that differentiates Dalio in this field is his ability to view whatever commodity he's looking at, say grain, as its own "economic machine", as he likes to call it. So he'd break the system into parts and deep dive each one. This exercise allows him to map out every cause-effect relationship within.

Most famously, Dalio had used this thinking to hedge McDonald's risk of unstable chicken prices before they released the McNugget in the 80s. As a result, Dalio's chicken trades were crucial to getting the McNugget to market.

It doesn’t get more iconic than that.

It's evident from the All Weather Portfolio that Gold stands on its own. Having a 7.5% allocation by itself (with all other commodities collectively making up 7.5%) shows Dalio's belief in the asset as an integral part of the portfolio to hedge inflation.

To all the Bitcoin maximalists, we don't have time today to delve into how Bitcoin is a 10x improvement on Gold but rest assured, we hear you…

Bonds

This is the asset that makes The All Weather Portfolio what it is - that which gives the portfolio the ability to perform well in various economic conditions and in different stages of the business cycle.

Bonds are debt instruments issued by corporations and governments to raise capital. When an investor buys a bond, they are lending money to the issuer (i.e. the government or corporation) in exchange for regular interest payments and the return of the principal invested upon maturity.

As you can imagine, this is how a significant portion of the world obtains financing - the Fed, for example, is the ultimate buyer of US Government Bonds, which becomes the primary mechanism for the central bank to pump money into the economy. By holding these securities, the Fed helps to manage short-term interest rates and the overall supply of credit in the economy. This then influences economic growth, inflation, and other key economic indicators.

That’s merely scratching the surface of “How The Economic Machine Works.”

Dalio's framework for investing in bonds anchors on the following:

• Adopting diversification by including a mix of bonds with different maturities, credit quality, and issuer types to reduce risk.

• Using Inflation-linked bonds to protect against the eroding purchasing power of the currency.

• Dynamic asset allocation by making tactical shifts in the portfolio to profit while balancing different risk types.

The approach is designed to provide a balanced approach to investing in bonds and has made him known as one of the most successful bond traders ever.

The most accessible point of entry to get exposure to Bonds, in line with the All Weather Portfolio allocations, is through the numerous ETF products that track US bonds. We recommend Chad stick to the products from the big players like BlackRock and Vanguard.

Before we finish up, it's worth remembering that the price of the bond asset and their yields move inversely to each other. Where we sit in today's markets, bonds can provide decent returns through their yields, with the Fed Funds Rate sitting around 5% (remember, the rate set by central banks drive bond yields).

Cash isn’t trash?

However, this all comes with a warning from Dalio himself. He's recently been incredibly outspoken about how being in cash at the moment could be more attractive than being in stocks or bonds, given current market uncertainty. Right now, cash can provide investors with healthy, risk-free returns through the higher deposit rates at banks we’re seeing.

If Dalio is reluctant to invest in markets today, Chad and the investing world should pay attention.

Smooth sailing ahead

We've travelled with Chad through the enigmatic world of Ray Dalio's All Weather Portfolio, and what an adventure it's been. From the realm of bonds to the shiny allure of gold, Chad's been on a whirlwind tour that's got him thinking.

He’s learned that one of the secrets to a more secure financial future isn't about aping into the latest meme coin or stashing his wealth in volatile stocks. No, it's about diversifying that hard-earned cash across a host of assets, each ready to take on whatever economic storm may be brewing.

A robust portfolio that can weather any season is like strapping a metaphorical parachute to your financial backside. You'll be prepared to glide through the ups and downs with less screaming and hair-pulling.

So what's the main takeaway here?

Learn from the “Steve Jobs” of finance and embrace the All Weather Portfolio. Be prepared for whatever shenanigans the market has in store.

After all, life's too short to lose sleep over a wildly swinging portfolio.

That’s all for today. If you found this post insightful, share it with a friend or anyone who might appreciate it.

Thanks for reading,

— Luca