What Are Your Rules? Learn From Ray Dalio

18388557 - man holding a business financial graph and chartAbout a week ago, I met a couple in my Falmouth office—let’s call them Al and Barbara. Al is a spunky 74 years young and Barbara is a youthful-looking 72. They are from West Falmouth and are looking for some guidance.
I began our initial meeting, as I always do, with the following question: “How can I help you?” Oh boy, what followed was very interesting. Al opened up by stating rather strongly that he is a staunch Trump supporter and thinks Hillary should be put in jail. Conversely, Barbara shot back at Al saying that Trump is a loose cannon and we need a woman in the White House. The “pleasantries” volleyed back and forth for what seemed like 15 minutes before I interjected and told them that my grandfather taught me to never discuss politics or religion in this type of forum (there was another topic in there that I will not mention in a family-friendly column).
I suggested we move on so they could tell me why they came to see me. Finally, they agreed on something. Al and Barbara both told me that they feel like the markets are going to take a major hit after this election and they don’t know what to do.
Hmm . . .
As you, Cutter Family Finance readers, know, using the word “feel” in the context of a discussion about investments is a recipe for disaster.
I sat back in my chair and told them a story about Ray Dalio, arguably one of the most respected investors and billionaires of our day. The story goes like this: In August of 1971, Ray Dalio was a young clerk working on the New York Stock Exchange for peanuts. Dalio was starting his career during one of our country’s critical turning points; the United States had just taken the dollar off of the gold standard.
Dalio’s feelings told him the market would crash the next day. Interestingly enough, quite the opposite happened; instead, it rallied. In fact, the Dow roared ahead to finish the day almost 4 percent higher.
Now, Dalio is a smart guy who learned a valuable lesson that day—a lesson that changed his life and the lives of many of his investors. He learned that the market has a knack for doing what you least expect it to do. He came to the conclusion that rather than to try to build an investment strategy from feelings and emotions, it is best to build strategies based upon rules. After his epiphany, he launched his firm Bridgewater & Associates, which has now become the largest hedge fund managing more than $160 billion.
There are a lot of similarities of the early 1970s and now. Back then, just like now, you had those Washington Wizards, the Fed, fooling around with things it shouldn’t, the markets. And back then, just like today, you had unexpected results.
I explained to Al and Barbara that I was not recommending that they pick up their things and go see Dalio. Frankly, even if they wanted to, they wouldn’t meet the minimum balance requirements. You need $5 billion in investable assets just to get through the door. While Al and Barbara have done quite well in their lives, they are just a few billion away from working with Ray.
Al agreed that the markets are very unpredictable, especially these days, and he feels that the Fed’s next move is anyone’s guess. He stressed that they are not mentally prepared for a financial hit like they have had in the past. Barbara spoke about how this election is like nothing we have ever seen. Al and Barbara both explained that now, more than ever, they need to be confident that their strategy will handle the unexpected, and they are not confident that their current strategy is equipped to do so.
Al and Barbara told me that in late 2008, their emotions got the best of them and they “sold out” of the markets, losing 44 percent of their wealth. They fear it is going to happen again if they do not make a change.
Through my evaluation of their current portfolio, I determined that they have a traditional 60/40 split between stocks and bonds. This model is very common within the brokerage world and with “do-it-yourself” investors. The theory is that when stocks go down, bonds go up, and vice versa. And by having a “balanced” portfolio an investor can minimize risk. Sounds good, right? But what happens if just about every asset class falls, and falls fast, just like in they did in 2008?
I explained to Al and Barbara that every investment strategy needs to be systematic and have established trading rules based upon historical quantitative data. Such strategies allow investors the highest probability of success in determining when to be bullish and when to be bearish. But in order to be successful, an investor must follow the rules.
One way to help remove feelings and emotions from investment decisions is to properly back-test an existing strategy to see how it behaves in both up and down markets. Once you understand a strategy’s behavior, you should either have faith in your system to do its job once a storm hits, or you should make a change. If you have no confidence in your existing strategy, then why continue with it?
I asked both Al and Barbara if they have investment rules. I asked if they have taken the time to back-test their existing strategy to see how it behaves. What if the market tanks in November? Or, more likely, what if Al gets out of the markets now, and we enter into a bull run?
You see, the most successful investors are those who either have a super-human ability to control their emotions (which rarely happens) or those who remove their emotions from the situation altogether. I told them that while my kids may think I am superhuman, in reality, I am not.
I introduced Al and Barbara to a Momentum Rules-Based System (MRBS), which is built to work in any market. An MRBS only buys or stays invested when a market sector is in an up-trend and has momentum on its side. This determination is based upon quantitative data to give the highest probability of success. And when the winds of change hit the sails, resulting in a downward trend, this same system indicates that it is time to move to a safe harbor. Having back-tested, quantitative rules in place removes all feelings from investment decisions. This is different from Al and Barbara’s buy-and-hold strategy where they stay invested all the time, on the way up, and on the way down . . . now that is an emotional roller coaster. And in a year such as 2008, well, those feelings can lead to very poor investment decisions.
I finished our meeting by telling Al and Barbara that I have no way of knowing exactly when the next major crash will be; I don’t think anyone does. However, what I can say with certainty is that when it hits, and it will, most investors will respond the wrong way, no matter who wins the White House. That’s because they will hold on for dear life on the way down and end up selling at the bottom, right before the market starts to rally again.
Emotions get the best of you every time. Don’t let them.
Learn from Ray Dalio: have a system based upon rules, and follow those rules.
Folks, what are your rules?
Be vigilant and stay alert, because you deserve more.