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Chances of Ray Dalio being right

September 28, 2012 | About:
Chandan Dubey

Chandan Dubey

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Suppose that you are tested for a rare disease. The disease is so rare that 1 in 100,000 people have it. The test itself is quite reliable in the sense that it makes a mistake in only 1% of the case. So, if you have the disease then the test will agree with 99% probability and disagree with 1% probability (these are called false negatives). Similarly, if you don’t have the disease then the test will be right with probability 99% and wrong with probability 1% (called false positives).

Now suppose that the test came out positive for you. What is the chance that you have the disease ? Is it close to 0.1%, 1%, 10% or 100% ?

***

Ray Dalio is the founder of Bridgewater Associates - the largest hedge fund in the world with nearly $122 billion in management. Since its origin in 1975, the fund has seen several ups and downs. Notably, it was one of the few hedge funds which returned +12% in 2008. How did Dalio manage such a return when S&P was down 37% for the year ?

A picture emerges from Maneet Ahuja’s book “The Alpha Masters”.



Dalio creates universal investment and management principles by learning from history. He analyzes how different countries, cultures, and people around the world react to different incidents like debt or oil shocks, for example, and figures out the variables that affected the different outcomes. Stripping away all the variables let Bridgewater arrive at universal laws for doing business. “If you’re limiting yourself to what you experienced, you are going to be in trouble. . . . I studied the Great Depression. I studied the Weimar Republic. I studied important events that didn’t happen to me.”

Dalio explains, “As risk at a particular period of time increases or decreases, it is either going to have a positive or a negative effect on certain markets and in various magnitudes.” For example, when dealing with bad economic conditions and higher default risks, Treasury bonds would have a positive beta, and equities would have a negative beta. And each instrument has various betas to it.“You can go back to Argentine stocks and certain emerging currencies,” Dalio says. “They all have various betas that we can see and adjust according to changes in the global risk environment. As a result, we pay attention to those things in structuring the portfolio. It’s a computer system that’s constantly updated.”


Let us ignore what Dalio does exactly. We simplify the model and assume that whatever Bridgewater does has an accuracy of 99%. This in my opinion is a very high accuracy rate for *any* model.

***

Did you solve the toy problem I posed at the beginning of the article ? If you haven’t please give it a serious thought before reading further.

The answer is 0.1% i.e., even if the test came out positive, there is a very small chance that you have the disease.

Let me explain. Consider a sample of 100,000 people. You expect 1 person in this sample to have the disease. If we test each and every individual in this sample using our test - it will come out positive for 1% of the healthy 99,999 individuals. This is a total of 999.99 false positives. So, you expect that nearly 1,000 people will test positive even when they do not have the disease. In this sample, only one person has the disease. Hence, the test gives at least 1,000 false alarms in a sample of 100,000 people.

If you tested positive, then what is the probability that you are the 1 out of 100,000 individual who has the disease ? It is at most 1/1,000 because of the 1,000 false alarms; which is a 0.1% chance of having the disease.

What happens if the disease is less rare ? If the disease occurs in 1 out of 10,000 people then the chance that you have the disease increases to 1%. For 1 out of 1,000 it stands at 10% and for 1 out of 100 it is nearly 100%.

***

Consider a situation in which Dalio’s model predicts an imminent major collapse in some market. If the event is sufficiently rare then with very high probability the model is wrong about the prediction.

If the event is not rare, then the prediction might be correct and useful. A major obstacle though is to calculate the rarity of an event. Can one claim that 2008 crisis was a rare event ? If yes, how rare ? Is it 1-in-10 or 1-in-100,000 ? How about the 9-11 attack on the World Trade Center or the World War 1 ? How rare are those ?

In hindsight, these events might be explainable but that does not mean that they were explainable while they were unfolding. The 1987 crash was short lived and the market was back to the peak in 1989. The internet bubble crash took nearly 5 years to reverse and immediately the market plunged back and is yet to recover completely.



***

Most of the time Dalio’s crisis indicator will say that it does not see an imminent major event. In these cases, most of the time the model will be right. But we don’t exactly need a model to tell us that the status is going to be “quo”. We need it when there is a risk of something drastic happening.

In case, the event which is going to happen is quite rare, whatever that means, the model is useless.

If the event is not a rarity then the model might be right. But unless it is completely mundane prediction like the rates are going to go up - the rarity of an event is nearly impossible to estimate correctly. Even predicting the direction the rates will go is close to impossible. Think of the rarity of 9-11 on Sep 8, 2009. Think of World War 1 and World War 2. Who thought that the interval between them will be only 20 years and then there will be no world wars until 2012 ? Can you predict the rarity of World War 3 ?

It is highly unlikely that anything usable comes out of the model Dalio has. Probably the only thing one can do is to get out of the corresponding market if the model raises an alarm. With very high probability it will be a false one, but at least you might be true in 0.1% of the cases and avoid huge losses. I am not sure how useful you think this strategy is. For me, Dalio’s model is quite expendable.

I will be happy to hear diverging opinions.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

Rating: 3.4/5 (22 votes)

Comments

mla
Mla - 1 year ago
I think you're a little too eager to dismiss Dalio's methods.

What about conditional probability? Sure, I couldn't have predicted 9/11. But are you saying we couldn't predict the tech bubble? We could, and we did. It was not a random event.

Similarly, how does this differ fundamentally from how a value investor analyzes a stock? It's all based on probabilities in one form or another. And there's always the chance of being wrong. That's why you try to maximize your margin of safety. That doesn't mean there isn't a chance of a "false positive."

To me, dismissing this sort of approach is akin to saying the markets are random and you might as well be in an index fund.
RunawayTrain
RunawayTrain - 1 year ago
I would be interested to know if you have achieved a long term growth rate as good as Dalio. Which is about 15%. It sounds easy, buy it isn't.
ecotycoon
Ecotycoon premium member - 1 year ago


Well it could be really really easy :) haha if you have less than 25 millions. Beating that is much more difficult specialy if you manage the amount Ray Dalio is having, almost no choice for him to play the Macro.
cdubey
Cdubey premium member - 1 year ago
@Mla: You are completely correct. Tech bubble was predictable. Probably the collapse of mortgage backed securities was also predictable. I mean, Michael Burry, Paulson, Rodriguez - all did it.

But for these, do you actually need a model to predict them ? Probably not. What value investors do is definitely not predicting some macro event, however rare.

You are right in claiming that "I am too eager to dismiss him". It comes out that way in the article.

To reach the conclusion you must satisfy the conditions for the conclusion to be true. So, we will take events that are sufficiently rare (or we think that they are rare). For example - the collapse of 1987, collapse of the Thai Baht in 1997, Russia defaulting on its debt in 1998 or 9-11.

Probably Dalio's model does not work for these events. It will be surprising if any model does. For these the model will be quite useless. It will also be quite useless in predicting "when" the internet bubble will burst or "how long" will the market take to reverse itself. But recognizing a bubble is not a random event and one should not conclude from the article that a bubble can't be recognized.

cdubey
Cdubey premium member - 1 year ago
Read the free excerpt from the Alpha Masters on Ray Dalio. I reproduce one of the gems here.

Dalio likens it to a two-column Chinese menu: choose your beta from column A and your alpha from column B. “We probably have 40 different benchmarks that the client can choose from,” he says. “How spicy do you like the alpha? If you want 6 percent volatility, you justput half the money in the 12 percent fund. If you want 18 percent volatility, you put 100 percent of your money in the 18 percent fund. If you want 1.8 percent volatility, you just take 10 percent of your moneyand put it into the 18 percent fund. It’s our best mix of alphas appliedto every account we manage,” says Dalio.

Either Dalio is kidding here or for someone who still believes in alphas and betas and systemic risks and the paragraph above - he has performed too well.

The chapter on Dalio is full of tidbits like this. Dalio is quoted as expressing many such simple country bumpkin kind of views. I am surprised indeed.
mla
Mla - 1 year ago
"But for these, do you actually need a model to predict them ? Probably not. What value investors do is definitely not predicting some macro event, however rare."

I'd suggest you are using a model in those cases, however. Not necessarily a mathematical model, but a model nonetheless (Munger's concept of the "lattice" work of mental models, perhaps).

And I don't understand why there's the hesitancy to predict macro events. The macro is just looking at the region/country/world-level "company." The fact that all macro events aren't equally predictable, doesn't imply none of them are.

I have no knowldge of the Thai Baht. So absolutely, for me, trying to predict its collapse would be akin to predicting randomness. But I don't assume that others, with a more intimate understanding, couldn't have predicted it. Was Soros' breaking the Bank of England an unpredictable event? Maybe to us. Not so sure it was random to Soros.

And timeframes are another issue entirely. I sat out the Internet bubble. I didn't need to be right in terms of timing. I just didn't need to participate. Often evading the big loss is more important than achieving the big gain.

I also sold my house in 2006. Not that I otherwise made money on the housing collapse, but again, it wasn't exactly a random event.

So the fact that the world's central banks are racing to devalue has no impact on your investing? To completely ignore these macro trends, and at the same time claim the ability to analyze companies, seems like a paradox to me.

Yes, maybe the "menu" of beta is crazy. I don't know and I'm not a Dalio cheerleader. I just think macro has a place.

Best,

Maurice
mla
Mla - 1 year ago
Ah, and just to follow-up on the Soros mention, check out his entry on Wikipedia. Looks like he was involved in the '97 Baht crisis too.

I guess one person's random event is another person's ironclad law of nature, eh?
superguru
Superguru - 1 year ago
I was located in Southern California at that time and pretty much everyone I talked to knew in 2005 that mortgage and housing market is going to end very badly but no one knew exactly when. So I was very surprised that fed reserve chairman did not know that.

cdubey
Cdubey premium member - 1 year ago
@Mla: 9/11 was quite random for everyone except the people who pulled it off !
batbeer2
Batbeer2 premium member - 1 year ago


>> I was located in Southern California at that time and pretty much everyone I talked to knew in 2005 that mortgage and housing market is going to end very badly but no one knew exactly when. So I was very surprised that fed reserve chairman did not know that.

Assuming he did know it, would he have said so?

mla
Mla - 1 year ago

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