Question

Ray Dalio and Warren Buffett are two wealthy and very famous investors who have different views on diversification.

1. Explain both their ideas on diversification.

2. Which side do you agree with? Why?

Initial Post Length: minimum of 500 words.

Answer 1

Ray Dalio and Warren Buffett's Views on Diversification

1. Warren Buffett's views on Diversification:

Billionaire investor Warren Buffett famously stated that "diversification is protection against ignorance. It makes little sense if you know what you are doing." In Buffet's view, studying one or two industries in great depth, learning their ins and outs, and using that knowledge to profit on those industries is more lucrative than spreading a portfolio across a broad array of sectors so that gains from certain sectors offset losses from others.

The need for diversification is a portfolio theory rooted in the idea that an investor who puts all his or her money in one company or one industry is flirting with disaster if that company or industry takes a dive.

Pros and Cons of Diversification:

These traders further diversify by selecting mutual funds and ETFs from different sectors that follow different trends. Some follow the ups and downs of the broader market, while others remain relatively flat. Still, others move inversely with the broader market, experiencing ups when most sectors are down and vice versa. The idea behind this strategy is that no matter what the market is doing, a portion of the investor's portfolio is likely to do well.

The problem with diversification, in the view of Buffett and other like-minded investors, is that even though the risk is mitigated by sector gains offsetting sector losses, the opposite is also true – sector losses offset sector gains and reduce returns.

Buffett has amassed a fortune by acquiring incalculable knowledge about all things finance and about specific companies and industries and using that knowledge to hand-pick his investments. Few investors have been better at picking stocks and timing entry and exit points. An ignorant investor – someone with little to no financial or industry knowledge – is bound to make blunder after blunder if he or she attempts to play the market the way Buffett does.

An investor who studies trends and has a keen understanding of how different companies and industries react to various market trends profits much more by using that knowledge to his or her advantage than by passively investing across a wide range of companies and sectors. Such an investor is able to go long on a company or sector when market conditions support a price increase; similarly, the investor can exit his or her long position and go short when indicators project a fall. The investor profits in either scenario and those profits are not offset by losses in unrelated industries.

Ray Dalio’s views on Diversification:

Dalio’s system of diversification through uncorrelated assets protects your returns while reducing your risk substantially.

Ray Dalio coined the concept of diversification as the “Holy Grail of Investing” in his book Principles, released in 2017. He sums up the concept this way:

With fifteen to twenty good, uncorrelated return streams, you can dramatically reduce your risks without reducing your expected returns.

He points out that most people have a mistaken understanding of diversification. They choose different assets within the same class, believing this is enough to protect their portfolios. However, as Dalio states:

Individual assets within an asset class are usually about 60% correlated with each other, so even if you think you’re diversified, you’re not.

His bottom line recommendation for building wealth is this:

Making a handful of good uncorrelated best that are balanced and leveraged well is the surest way of having a lot of upside without being exposed to unacceptable downside.

In his written and spoken workshops for investors, Dalio emphasizes the steps needed to reduce the return to risk ratio by a factor of five. In other words, you keep your level of risk the same while increasing returns five times over. This, he says, is the key to building a strong portfolio that maximizes both short-term and long-term returns.

Ray Dalio All Weather Portfolio:

Dalio’s status as a self-made billionaire, and the success of his firm, Bridgewater Associates, makes him an important voice in the investing world. He offers common-sense investment strategies and methods that can be duplicated by average people when they put time and effort into thorough research.

One of the most popular concepts Dalio has developed is the All Weather Portfolio. This is a collection of investments that is carefully designed to survive unscathed through any sort of market turbulence.

According to Dalio, there are four possible “seasons” in the global economy at any given time:

• Periods of high inflation, when prices go up and purchasing power goes down
• Periods of deflation, when the prices of goods and services don’t increase as quickly as expected or decrease
• Periods of improving economic growth
• Periods of declining economic growth

Obviously, these four “seasons” are incompatible – they cannot occur simultaneously. A portfolio capable of growing regardless of “season” is a rare mix – and holds the secret to sustainable returns.

2. I Agree With...:

I agree with Warren Buffett. This is primarily because of his continuously successful track record as an investor for nearly 60 years. By achieving average annual returns of ~20% consistently over the better part of a century, may consider him as the greatest investor of all time.

• Buffett doesn’t criticize diversification; he criticizes over-diversification. He advocates the average investor should have 90% in S&P and 10% in bond governments - not 5 funds for example
• The academic evidence shows that long-term investors do benefit from being mostly in markets
• Government bond allocations are something that older people should have. 10% is fine for younger people, or even people who are 45 or 50.
• 10% is too low for somebody close to retirement
• Diversification just lowers volatility
• Volatility and safety/risk aren’t connected
• More volatile assets outperform less volatile ones
• People who over-diversify are usually petrified of any volatility
• Too many people over-complicate investing; it is easy to get wealthy on a middle-income
• Market timing and over diversification don’t help people get wealthy. But neglecting bonds entirely doesn’t make sense.

Ray Dalio is also interesting, even though for other reasons and those reasons are mainly his comments on management style, thoughts on macro-economics and other topics. His is a good investor, although not on the same level as Warren Buffett.