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Have you ever wondered if there's a perfect number of shares you should own to maximize profits and minimize risk? Is there a perfect strategy, a master plan you can use? And this is a question that I'm sure has occupied Dalio's mind for a long time. How can I perfectly balance my investment strategy ?
And Ray Dalio, I don't know how long he's been working on this strategy, probably years, experimenting with different variables and quantities like a scientist would, only instead of chemicals, Dalio focuses on investments. And over time, he developed a strategy called the holy grail of investing. The Holy Grail strategy answers the question, how do we structure our portfolio to obtain maximum profits with the least possible risk?
Fortunately, Dalio has not kept this strategy to himself. She shared it with the world. And I'm going to teach you this strategy in this video. It's a very important one. Okay, I need you to pay attention to this chart. Now, it may seem a little confusing, perhaps with too many lines for you, but I'm going to explain it in a very simple way.
So, on the left side of the graph, we have the standard deviation of the portfolio. This is simply a way to measure risk. Uh, okay. At the bottom of the chart, we have the number of assets in the portfolio. These can be stocks, gold, real estate, any type of asset. So, we have risk, we have the number of assets, and the third ingredient of this chart is correlation.
So, that's the correlation between each asset. Now, for those who don't know what correlation means, it simply means how connected the assets are or how strongly linked they are to each other. For example, the stocks of Coca-Cola and Pepsi will have a strong correlation because their consumers are similar, their business model is similar, and they are strongly connected.
Whereas , say, Costco, an American retailer, and the Royal Bank of Canada, have a weak correlation because they are in completely different countries and have totally different business models. So, let's go back to the graph. Okay, now let's get down to business, the important part of all this. So, with this chart, we assume that we have an asset that has a 10% risk and a 10% standard deviation.
And to simplify, we also assume that the asset has a 10% return. And then you add a different asset with the same return up to 10, 20, 30 times, however many assets you want to add. The question is how it affects the amount of assets you add to the overall portfolio risk . And the interesting thing you'll notice is that the more of these assets you have, the lower your risk becomes.
You see, as you move along the X-axis, the more stocks and assets you own, the lower the risk becomes. And that's why Dalio says diversification is not for idiots. It's really for wise people. And Dalio said: "Knowing how to diversify well is more important than almost anything else ." But note that he said to diversify well , because you don't need to own hundreds of different stocks to be well diversified.
You see, if you look at this chart we've been analyzing, there's a point where further diversification doesn't make much difference. You see, beyond 15 to 20 different stocks, there isn't a significant decrease in risk. So that tells us that, when it comes to our portfolio, 15 to 20 stocks is all we need to be well diversified with the least possible risk.
And that's a very important thing to know when it comes to your overall portfolio. 15 to 20 actions, when you look at the science behind it, is all we need. However, there is more to it than that. What you'll notice about this graph is that there are five different lines. Now, each of these lines represents a certain level of correlation between the assets.
The red line at the top has a 60% correlation between each asset, and the green line at the bottom has a 0% correlation. So, I hate to state the obvious, but the lower the correlation between each asset, the lower the risk. As you can see, the red line at the top has a risk-reward ratio of around 0.31 , giving it a 38% chance of losing money in a given year.
However, the green line with 0% correlation across 20 stocks only has about a 12% probability of losing money in a given year. So with the lower correlation line, you maintain the same performance as the higher line, but reduce the risk four times. That's why it's so important, if you're looking to build a well- diversified portfolio, to buy stocks that aren't strongly related.
You know, look to buy stocks in different industries such as consumer staples, travel, technology, finance. Well, these industries aren't closely linked, so your risk will be drastically reduced. As Dalio says, the magic lies in the fact that you only need to do this simple thing. The easy part is finding 15 to 20 good, uncorrelated sources of income.
If you achieve this, you can improve your risk-return ratio by a factor of five. And the curious thing about risk is that people often don't understand it when it comes to their investment style. All they care about is how much they can earn. Only the experienced investor who has gone through their fair share of ups and downs understands the importance of risk.
Like Warren Buffett, his first rule of investing is not to lose money. Their second rule is not to forget rule number one. What he means is managing risk well. Pay attention to your disadvantage. You know, I'll give you a small example. Let's say you own a stock. We will call this action Orange. Orange is selling for $100 a share.
If Orange drops 50%, it now sells for $50 a share. But if it goes up 50% the next day, it's only worth $75. So , even though it went down and up by the same percentage, you've now lost a quarter of your investment. If it falls by 50%, it needs to rise by 100% to fully recover. And this is a perfect example of why managing risk is so important, possibly even more so than your potential reward.
And that is why Dalio's "holy grail" strategy is so important to all investors, because it greatly reduces risk. So now the obvious question is, how do we practically implement this strategy with our own portfolios? This is what I'm going to show you in the last part of the video. Remember that the holy grail is 15 to 20 uncorrelated income streams, and fortunately, Dalio has given us good information on how we can implement it.
Essentially, we can narrow it down to four different types of environments in which we want our portfolio to perform well. Good. Environments of rising inflation with increasing growth. Environments of decreasing inflation with increasing growth. Environments of rising inflation with declining growth.
And environments of decreasing inflation with decreasing growth. Four types of environments. So, in the growing growth section , when growth is high, you want to be in stocks. You don't have to be a genius to figure that out . And I personally believe that the stock side of one's portfolio is the most important because, throughout history, it has offered the greatest returns.
This is how Buffett became so rich. Not through bonds , cash, or gold. No, it was through the shares. As far as equities go, you really want to have exposure to the US and other developed markets. These tend to work well in low or declining inflation environments. And you should make sure you're in a variety of different sectors that have low correlation with your stocks.
For example, travel actions versus consumption actions. As we have seen recently during the lockdown, travel stocks were hit hard in price because nobody was traveling. However, defensive consumer stocks like Walmart or Target performed relatively well. Both have increased substantially in price . So, travel stocks fell, consumer stocks rose.
Because? Because they have a relatively low correlation. When it comes to stocks, make sure they're not all in one sector, but in several different sectors. Another thing to consider with stocks is diversifying across countries. Emerging markets behave differently than developed markets and tend to perform well in periods of high inflation.
Therefore, a well-diversified portfolio will have stocks in both developed and emerging markets. But, at least according to Dalio, to be well diversified you need more than just stocks. Of course, gold is a big component of Dalio's portfolio and investment style. As you can see, it works well in all three different types of economic environments.
But, in general, it's a good way to protect your wallet. By this I mean that often, when many asset classes are doing poorly and people are panicking, gold is doing well. And that's exactly what coverage is for. So, when it comes to the holy grail strategy, gold is great as one of your uncorrelated assets.
In this chart, Dalio offers more examples. Commodities and emerging market bond spreads perform well in environments of rising growth and inflation . Inflation-protected bonds , long-term Treasury bonds, developed bond spreads, medium-term Treasury bonds, and cash are more assets that Dalio exemplifies as uncorrelated income streams that you can use.
At this point, I would recommend pausing the video and seeing what income streams are missing from your portfolio that you might want to add, because doing so will help reduce your risk, which is very important. As Dalio says, many people think that the most important thing you can do is find the best investments.
That 's important. Alright. But there's no big investment that can compete with something like this. The Holy Grail strategy. The Holy Grail. It is the ideal point between diversification and correlation. You don't need to own hundreds of different stocks to be well diversified. According to statistics and data, 15 to 20 uncorrelated income streams are all you need.
As Dalio says, it's the safest way to have high profit potential without being exposed to unacceptable risks.
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