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The Hedge Fund Manager's 'Holy Grail' of Investing

February 01, 2013 | About:

Holy grails are the stuff of myth and legend.

But imagine the most successful hedge fund manager on the planet had an investing "grail"... and was willing to share its secrets with you.

The manager is real. (And so is his grail.)

Ray Dalio started his fund, Bridgewater Associates, from his bedroom in his Manhattan apartment in 1975 with just $3 million under management. Now, Bridgewater manages more than $130 billion in assets.

More important, the firm has earned more than $50 billion in profits for clients, with almost zero correlation to the stock market (meaning it doesn't matter to Bridgewater whether stocks go up or down).

So what is Dalio's "holy grail"?

It's all about reducing the correlations how closely different assets move together within your portfolio.

Most people think that by just owning lots of different stocks, they are reducing their risk through diversification. But the problem is that all stocks are strongly correlated to one another.

That means a long-only stock portfolio will always have some meaningful degree of correlation... and carry the risk of everything going in the wrong direction at once.

But by holding non-correlated assets in your portfolio, you dramatically reduce this risk and help keep your investments safe.

Put another way, the lower correlations are among the assets in your portfolio, the lower the risk you carry of a "ruinous loss" when markets crash. That's because as one asset falls in price, another is more likely to be rising or staying flat.

According to Dalio, by combining assets that have an average zero correlation (meaning they move randomly in relation to one another), by the time you get to more than 15 assets you can cut the overall volatility in your portfolio by 80%. And you can boost your risk-reward ratio by a factor of five.

I don't want you to get too hung up on the math — or the technical aspect of correlations. By following the three recommendations below, you will dramatically reduce your risk of a big portfolio wipeout, and therefore also dramatically enhance your returns over the long run.

Diversify Across Direction

A long time ago (the 1980s and 1990s) in a galaxy far, far away stocks did nothing but go up. But these days, stock markets go down as well as up. And when they go down they can go down big time.

This means the "dark side" of investing, going short, has a lot more going for it these days. By pursuing bearish ideas as well as bullish ones, you greatly reduce the correlations within your portfolio.

Diversify Across Borders

Stock markets can behave differently from one country to the next. So, by looking beyond America's borders — and investing in different countries around the world — you further reduce the correlations in your portfolio.

This is also a great way of capturing strong returns. As the old saying goes, "There's always a bull market somewhere." By investing overseas, you are much more likely to benefit from one than by concentrating all your investments at home.

As of Friday, here are some of the world's best and worst performing stock markets. (Notice how wide the range is.)

Argentina: +17%

Vietnam: +13%

Nigeria: +12.5%

China: +1%

Brazil: +0.4%

South Korea: -2.5%

Diversify Across Asset Classes

I also recommend you take Dalio's advice and diversify your portfolio across different asset classes. In addition to stocks, bonds, currencies, commodities and precious metals are all worth considering.

The greater the number of truly independent investing ideas you can find, the easier it will be for you to sleep at night. And because you will avoid big portfolio drawdowns, the stronger your returns will be over time.


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