MONEY Master the Game: 7 Simple Steps to Financial Freedom (57 page)

If you grew up in the Roaring Twenties, your life was shaped by prosperity and grandeur. It was the days of the Great Gatsby. But if you grew up during the Great Depression, your life was shaped by struggle and anxiety. Growing up in a severe economic “winter” forced you to become a survivor.

Today’s generations have a completely different experience of the world. They have grown up in incredible prosperity, even if their incomes don’t land them in the 1%. We all get the benefits of living in an on-demand world. We can have groceries delivered to our door, deposit checks from the comfort of our pajamas, and watch thousands of television channels whenever and wherever we choose. My granddaughter hasn’t learned to tie her shoes, but at age four she can navigate an iPad as well as I can, and she already knows that Google can answer any question she has on a moment’s notice! This is also the era of possibility, where a start-up like WhatsApp, with only 50 or so employees, can disrupt an industry and sell for $19 billion!

Without a doubt, our lives are shaped by the seasons and events through which we live, but more importantly, it’s the meaning we give those events that will determine our ultimate trajectory.

THE 1970S

Ray Dalio, now 65, came of age in the 1970s. It was a time of violent change in seasons and arguably the worst economic environment since the Great Depression. High unemployment was accompanied by massive inflation, causing interest rates to skyrocket into the high teens. Remember I shared with you that my first mortgage coming out of the inflation of the 1970s was a whopping 18% interest! There was also an “oil shock” in 1973, as an embargo caught the United States off guard, causing oil prices to rise from $2.10 a barrel to $10.40. No one was prepared for this. Just a few years later, the government imposed odd-even rationing, where people were forced not only to wait in line at the pump for hours but also were allowed to gas up only on odd or even days of the month! It was a season of political strife as faith in our government dwindled after Vietnam and Watergate. In 1974 President Nixon was forced to resign and was later pardoned by his successor, former vice president Gerald Ford, for any wrongdoing (wink, wink).

In 1971 Ray Dalio was fresh out of college and a clerk on the New York Stock Exchange. He saw bull and bear markets come in short bursts and create massive volatility in different asset classes. Tides changed quickly and unexpectedly. Ray saw the huge opportunity but was equally or even more aware of the enormous risks that came with the territory. As a result, he became ferociously committed to understanding how all these scenarios and movements were intertwined. By understanding how the bigger economic “machine” worked, he would ultimately figure out how to avoid those cataclysmic losses that doom so many investors.

All of these events shaped young Ray Dalio to ultimately become the world’s largest hedge fund manager. But the seminal moment that most shaped Ray’s investment philosophy happened on a hot night in August 1971, when a surprise address from President Nixon would change the financial world as we know it.

A NIXON NIGHT

All three major networks had their broadcasting interrupted unexpectedly as the president of the United States suddenly appeared in living rooms across America. In a serious and agitated state, he declared, “I directed Secretary
[John] Connally to suspend temporarily the convertibility of the dollar to gold.” In one brief sentence, just 14 words, President Nixon announced to the world that the dollar as we knew it would never be the same again. No longer would the dollar’s value be tied directly to gold. Remember Fort Knox? It used to be that for every paper dollar, the government would have the equivalent value of physical gold stocked away safely. And with Nixon’s declaration, the dollar was now just paper. Imagine you had a treasure chest filled with gold, only to open it one day and find a yellow paper sticky note that said simply “IOU.”

Nixon was saying that the dollar’s value would now be determined by whatever we (the market) deemed its worth. This news also shocked foreign governments that had held huge sums of dollars, believing that they had the option to convert to gold at any time. Overnight, Nixon removed that option from the table (once again living up to his nickname “Tricky Dick”). Oh, he also issued a 10% surcharge on all imports to keep the United States competitive. And like a blizzard in late October, Nixon’s address signified a change in seasons of epic proportions.

Ray was watching the president’s address from his apartment and couldn’t believe what he was hearing. What were the implications of Nixon’s decision to take the United States off the gold standard? What did it mean for markets? What did this mean for the US dollar and its position in the world?

One thing Ray thought for sure: “It means the definition of money is different. I would have thought maybe it’s a crisis!” He was certain that when he walked onto the trading floor the next morning, the market was sure to plummet.

He was wrong.

To his amazement, the Dow Jones was up nearly 4% that next day, as stocks soared to the highest single-day gain in history. Gold also skyrocketed as well! It was completely counterintuitive to what most experts would expect. After all, we had just broken our sacred promise to the world that these pieces of paper with dead presidents on them were actually worth something of value. Surely this change wouldn’t inspire confidence in the US economy or government. This was a head scratcher. This market boom eventually became known as the “Nixon rally.”

But it wasn’t all great news. By letting the value of the dollar be
determined by “whatever we all think it’s worth,” an inflationary storm brewed on the horizon. Ray elaborates: “But then in 1973, it set up the ingredients for the first oil shock. We never had an oil shock before. We never had inflation to worry about before. And all of those things became, in a sense, surprises. And I developed a modus operandi to expect surprises.” It’s the surprises that we can’t afford, or stomach. It’s the next 2008. It’s the next shock wave sure to rumble through our markets.

The Nixon rally was a catalyst for Ray: the beginning of a lifelong obsession to prepare for anything—the unknown around every corner. His mission was to study every conceivable market environment and what that meant for certain investments. This is his core operating principle that allows him to manage the world’s largest hedge fund. Not espousing that he knows all. Quite the opposite. He is insatiably hungry to continually discover what he doesn’t yet know. Because what’s obvious is obviously wrong. The prevailing thought is usually the wrong thought. And since the world is continually changing and evolving, Ray’s journey to uncover the unknown is a never-ending endeavor.

ULTIMATE INVESTOR NIRVANA

What you are about to read could very well be the most important chapter in the entire book. Yes, yes, I know, I said that before. And it’s true that if you don’t know the rules of the game, you will get crushed. And if you don’t think like an insider, conventional wisdom will lead you to accept the fate of the herd. And if you don’t decide on a percentage and automate your savings, you will never get the rocket off the ground. Yet I wholeheartedly believe that there is nothing in this book that tops Ray’s strategy for the largest returns possible with the least amount of risk. This is Ray’s specialty. This is what Ray is known for throughout the world.

The portfolio you are going to learn about in the pages ahead would have provided you with:

1. 
Extraordinary returns—nearly 10% annually (9.88% to be exact, net of fees) for the last 40 years (1974 through 2013)!

2. 
Extraordinary safety—you would have made money exactly 85% of the time over the last 40 years! There were only six losses during those 40 years, and the average loss was only 1.47%. Two of the six losses were breakeven, for all intents and purposes, as they were 0.03% or less. So from a practical perspective, you would have lost money four times in 40 years.

3. 
Extraordinary low volatility—the worst loss you would have experienced during those 40 years was only –3.93%!

Remember Warren Buffett’s ultimate laws of investing? Rule 1: don’t lose money. Rule 2: see rule 1. The application of this rule is Ray’s greatest genius. This is why he is the Leonardo da Vinci of investing.

Anybody can show you a portfolio (in hindsight) where you could have taken gigantic risks and received big rewards. And if you didn’t fold like a paper bag when the portfolio was down 50% or 60%, you would have ended up with big returns. This advice is good marketing, but it’s not reality for most people.

I couldn’t fathom that there was a way for the individual investor (like you and me) to have stock market–like gains, yet simultaneously have a strategy that would greatly limit both the frequency and size of the losses in nearly every conceivable economic environment. Can you imagine a portfolio model that declined just 3.93% in 2008, when the world was melting down and the market was down 50% from its peak? A portfolio where you can more than likely be safe and secure when the next gut-wrenching crash wipes out trillions in America’s 401(k) accounts? This is the gift that lies in the pages ahead. (Note that past performance does not guarantee future results. Instead, I am providing you the historical data here to discuss and illustrate the underlying principles.)

But before we dive in, and before you can appreciate the beauty and power of Ray’s guidance, let’s understand the backstory of one of the most incredible investors and asset allocators to walk the planet. Let’s learn why governments and the world’s largest corporations have Ray on speed dial so they can maximize their returns and limit their losses.

I’M LOVIN’ IT

Nineteen eighty-three was a bad year for chickens. It was the year that McDonald’s decided to launch the wildly successful “Chicken McNugget.” They were such a hit that it took a few years to work out supply-chain issues
because they couldn’t get their hands on enough birds. But if it wasn’t for the genius of Ray Dalio, the Chicken McNugget wouldn’t even exist.

How does the world of high finance intersect with the fast-food-selling clown? Because when McDonald’s wanted to launch the new food, it was nervous about the rising cost of chicken and having to up its prices—not an option for its budget-conscious clientele. But the suppliers weren’t willing to give a fixed price for its chickens because they knew that it wasn’t the chickens that are expensive. It’s the cost of feeding them all that corn and soymeal. And if the feed costs rose, the suppliers would have to eat the losses.

McDonald’s called Ray, knowing that he is one of the world’s most gifted minds when it comes to eliminating or minimizing risk while maximizing upside—and he rang up a solution. He put together a custom futures contract (translation: a guarantee against future rising prices of corn and soymeal) that allowed suppliers to be comfortable selling their chickens for a fixed price. Bon appétit!

Ray’s expertise extends far beyond the boardrooms of major corporations. Just how far does his wisdom reverberate throughout the world?
In 1997, when the US Treasury decided to issue inflation-protected bonds (today, they are commonly known as TIPS), officials came to Ray’s firm, Bridgewater, to seek advice on how to structure them.
Bridgewater’s recommendations led to the current design of TIPS.

Ray is more than just a money manager. He is a master of markets and risk. He knows how to put together the pieces to tilt the odds of winning drastically in favor of him and his clients.

So how does Ray do it? What’s his secret? Let’s sit at the feet of this economic master and let him take us on a journey!

INTELLECTUAL NAVY SEALS

Remember the jungle metaphor Ray gave us way back in chapter 1? As Ray sees it, to get what we really want in life, we have to go through the jungle to get to the other side. The jungle is dangerous because of the unknowns. It’s the challenges lurking around the next bend that can hurt you. So, in order to get to where you want to go, you have to surround yourself with the smartest minds that you also respect. Ray’s firm, Bridgewater, is his personal team of “jungle masters.” He has more than 1,500 employees who are
almost as obsessed as Ray with figuring out how to maximize returns and minimize risk.

As I mentioned early on, Bridgewater is the world’s largest hedge fund, with nearly $160 billion under its watch. This amount is astonishing, considering most “big” hedge funds these days hover around $15 billion. Although the average investor has never heard of Ray, his name echoes in the halls of the highest places. His observations, a daily report, are read by the most powerful figures in finance, from the heads of central banks to those in foreign governments, and even the president of the United States.

There is a reason why the world’s biggest players, from the largest pension funds to the sovereign wealth funds of foreign countries, invest with Ray. And here is a clue: it’s not “conventional wisdom.” He thinks way outside the box. Heck, he shatters the box. And his voracious appetite to continually learn and challenge the conventional and find “the truth” is what propelled Ray from his first office (his apartment) to a sprawling campus in Connecticut. His jungle team at Bridgewater has been called a group of intellectual Navy SEALS. Why? Because by working at Bridgewater, you are going through the jungle with Ray, arm in arm. The culture requires you to be creative, insightful, and courageous—always able to defend your position or views. But Ray also requires that you have the willingness to question or even attack anything you consider faulty. The mission is to find out what is true and then figure out the best way to deal with it. This approach requires “radical openness, radical truth, and radical transparency.” The survival (and success) of the entire firm depends on it.

ALPHA DOG

Ray Dalio put himself on the map with the extraordinary (and continual) success of
his Pure Alpha strategy. Launched in 1991, the strategy now has $80 billion and has produced a mind-boggling 21% annualized return
(before fees were taken out), and with relatively low risk. The fund’s investors include the world’s wealthiest individuals, governments, and pension funds. It’s the 1% of the 1% of the 1%, and the “club” has been closed to new investors for many years. The Pure Alpha strategy is actively managed, meaning that Ray and his team are continuously looking for opportunistic investments. They want to get in at the right time and get out at the right
time.
They aren’t just riding the markets, which was evidenced by a 17% gain (before fees) in 2008 while many hedge fund managers were closing their doors or begging investors not to pull out.
The investors in the Pure Alpha strategy want big rewards and are willing to take risks—albeit still limiting their risk as much as humanly possible.