Original Title: Investment Principles: What Should You Do Under Existing Conditions?
Original Author: Ray Dalio, founder of Bridgewater Associates
Original Translator: Peggy, BlockBeats
Editor's Note: In the context of AI giants continually driving up US stock indices and increasing market concentration, Ray Dalio revisits a classic question in this latest note: How should investors allocate assets when a revolutionary technology is changing the world?
Dalio's core reminder is that technological advancement does not equate to the related stocks being equally attractive. Significant technology cycles in history often experience excitement, crowding, volatility, and clearing, even companies like Microsoft and Apple, which have long been successful, have encountered significant pullbacks during these cycles. Today's AI industry also faces multiple uncertainties such as over-investment, intensified competition, geopolitical issues, tax policies, anti-AI sentiments, and disruption from next-generation technologies.
The most important point of the article is not whether AI will change the world but rather how investors should respond to a "highly concentrated" market structure. Dalio believes when a few technology companies dominate an increasingly high weight within indices, investors need to be wary of unconsciously holding high-correlation, high-risk concentrated exposures. Instead of continuing to chase a few leading companies, a more robust approach is to build a diversified portfolio composed of high-quality, low-correlation assets and adjust the level of volatility according to one's risk tolerance.
In his view, knowing what you don't know is as important as knowing what you do know. In the current market environment driven by AI, characterized by high valuations and concentrated risks, investors should not directly translate their excitement about new technologies into concentrated investments in a few AI stocks. Diversification, in Dalio’s eyes, is the "investment holy grail" to navigate this technological cycle.
The following is the original text:
This note discusses: how one should participate in the investment game under the current environment.
Imagine you are playing bridge, poker, backgammon, or chess, and it’s your turn to make a move, while you have a computer next to you that can evaluate the situation and suggest the next step. To me, investing is like this game. Whether or not you have a computer to assist, I believe you should:
Based on the current situation on the board, ask yourself what the next move should be. That is to say, you need to decide how to act based on the existing characteristics of the market and the various forces affecting the market.
I have been engaged in this investment game for a long time. At this stage, my goal is to convey how I would play this game; furthermore, I aspire to create a platform that allows various individuals to explore the investment game in their desired manner, learn, backtest how they would have performed in the past, and truly excel at it. I believe there is a right and wrong way to handle the cards one has. Therefore, when you encounter a situation like XYZ, you should ask yourself, "How should I place my bet in this situation?" and be able to provide a good answer.
Now, I want to share with you the current market characteristics as I see them, what I think should be done, and what I am actually doing.
How to Respond to the Current Set of Conditions
What are the most important environmental factors right now? Under these factors, how should one place their bets?
In my view, and possibly in the view of most people, the market environment we are currently in is: an industry primarily driven by significant new technology, mainly AI, where only a very few companies dominate market trends. These companies occupy a high proportion of the total market capitalization and have a significant impact on the market and the economy. All such periods have a common feature: a massive amount of excitement, uncertainty, and volatility concentrated in the new technology industry, which is transmitted to global stock markets. Hence, the volatility and uncertainty surrounding this industry are very important.
In addition, there are some uncertainties related to other significant driving forces. I refer to these driving forces as the "Five Major Forces": 1) What is happening with debt and currency; 2) What is happening with political and social issues that may significantly impact taxes and other politically driven market factors; 3) What geopolitical factors are affecting the market, such as war; 4) What natural forces are at play; 5) What new technologies are emerging. I input these situations into my investment system to let it consider how to bet under these environments, while I also think independently about what to bet on.
When thinking about how to place bets in these environments, the most important question is: What kind of choice do you really want to make? a) Bet more heavily on new technology compared to broad stock indices, like the S&P 500, by overweighting this new industry or overweighting the few best companies within that industry; b) Maintain an exposure roughly around index weight; or c) Diversify away from this concentration?
Almost everyone wants to buy the best investments and strives for that, and right now there seems to be a technology that is changing almost everything. However, history shows that at this stage of the cycle, most people fail because they place a large proportion of their bets on the stocks of a few leading technology companies. There are logical reasons behind this, and it has always evolved in this way in the past. While this time AI technology is indeed unique, there have been many other "unique" new technologies in history that can serve as analogies and references. People should study these cases; if one chooses to ignore them, they must be able to explain well why this time is different.
Risks Are Undoubtedly High
All significant new technology cases in the past have unfolded in similar ways due to the same logical reasons. High risks and immense uncertainties are inherent characteristics of these new technology companies. Looking back at the performance of these companies under similar environments in history, we find that even the best revolutionary new technology companies with long-term prosperity, such as Microsoft and Apple, have faced significant setbacks during similar stages of their development. Moreover, when these new technology companies first emerged, and not in hindsight, it was not easy for people to determine which companies would succeed and which would fail, like IBM. If you observe all these cases, you will see that major new technology companies have a highly uncertain future by nature.
For example, they either over-invest or under-invest. The reason is that if they do not invest enough to win the competition, they will definitely lose; however, they cannot precisely know what will happen in the future to determine whether they have over-invested. Regardless of whether it's over-investing or under-investing, the cost is high.
Additionally, they cannot accurately foresee all changes, including exogenous changes such as tightening monetary policy, war, drastic tax changes, etc., all of which can affect them. Thus, they will experience severe upward and downward cycles: first exciting investors, then scaring them, and washing out weak investors, ultimately leading to exaggerated market volatility. Furthermore, just as these new technologies and new technology companies have once disrupted predecessors, most of them will eventually be disrupted by newer technologies and newer technology companies in ways we cannot foresee. Therefore, we should also consider whether the same risks could occur with these new technologies and technology companies today. The impact of quantum computing is one of the known unknown risks. What about the risks that have yet to be imagined?
What about the risks posed by competitors? For example, China is producing and distributing AI technologies, with policymakers there having completely different views on the economy and AI. We are in a new technology war, and leaders in various countries believe they must win this war. Their understanding of AI and its impacts on the economy and people's welfare will lead them to offer this technology for free or at low cost, as it has enormous productivity benefits and can significantly enhance living standards. In their view, overall benefits of many people using these new technologies are more important than profits. I believe they will compete in international markets, just as they have in automobiles, solar panels, batteries, and many other products.
The current set of conditions resembles many historical cases that provide lessons. I cannot help but think about how Britain defeated the Netherlands in shipbuilding and other vital industries during the late Dutch Empire and the beginning of the British Empire. Moreover, there is a geopolitical conflict surrounding Taiwan that should at least lead us to consider one possibility: as a geopolitical weapon of war, China may prevent chips from flowing out of Taiwan. AI stocks also face other risks, such as the risk of wealth taxes and other tax increases that could force holders with substantial concentrations in these stocks to sell; or rising anti-AI sentiments that might limit companies' ability to advance technological development.
I could list even more concerning issues for you, as well as a similarly long list of tremendous opportunities that AI will create and I want to bet on. I am not saying that these risks will definitely evolve in one way or another, nor am I saying one should not bet on AI companies. I am simply stating that there is a significant concentration risk in the market, which is indisputable; and people should be aware of how to respond in such an environment. Based on my research of all similar cases and the logical reasons behind them, I am convinced that the risks are high, and the best way to deal with this environment is:
To Focus on Diversification
You may know that my mantra is "diversification." My "investment holy grail" is: strive to hold 15 high-quality, uncorrelated investments that are risk-balanced. In other words:
A well-diversified portfolio composed of high-quality bets will outperform a single concentrated bet. It has a better risk-return ratio, and it can be engineered to achieve better returns at the same level of risk. The more concentrated the risks in the market within a specific area, the more one should diversify; especially when the market is driven by revolutionary new technology, as this technology itself generates immense uncertainty.
This is not a matter of opinion, but a mathematical certainty. For example, if I compare an investment with a risk-return ratio of 0.3, assuming it has a return rate of 6% and a standard deviation of 18%, which is typically what people assume for stocks; then, if I hold 5, 10, or 15 uncorrelated investments, I can achieve the same 6% return, but the risk measured by standard deviation will drop to 8%, 6%, and 5% respectively. Therefore, if holding 15 high-quality and uncorrelated investments, my risk-return ratio would increase 4.3 times, from 0.3 to 1.29. If you are willing, you can also leverage this to achieve much higher returns at the same risk level. This is a fact.
I am very confident about this. The reasons come from my backtests, the actual returns I have delivered over more than 50 years of investing, and the probability logic inherent in them: excellent bets based on diversification and adjusting them to the level of volatility you wish to undertake will, over the long term, yield far better returns than the concentrated bets most investors tend to hold. More specifically, through good diversification, one can achieve a better risk-return ratio than any concentrated bet; furthermore, adjusting it to the risk level one wishes to assume can yield higher returns at the target risk level, which is superior to any other process.
Because I am passing on this approach, it has become my “not-so-secret” way to investment success. Nevertheless, I rarely encounter investors who think of investing strategies in this way. That is to say, I seldom meet those who genuinely consider portfolio construction, thinking about how a well-structured, diversified betting portfolio would perform compared to holding stocks in a great new transformative industry. Most people are only thinking about whether these stocks and this industry will perform well and how to bet on them. Those who think about portfolio construction and those who do not will ultimately experience vastly different outcomes in performance. Therefore, I will elaborate further on my ideas about how to do this more completely at another time.
For all these reasons, when considering how to play the cards you have well in the current set of conditions, it should lead one to ask: How large of a concentrated bet should I hold? And then diversify.
Returns Appear to Be Low
High risk is indisputable. Next, I am going to present a possibly erroneous perspective: Future expected returns are low. My judgment on future expected returns comes from valuation-related analytical work and my bubble indicator readings: the real returns on stocks over the next 5 to 10 years appear to be around -5% to -10%, although there is considerable uncertainty surrounding these numbers. In my view, these stocks are long-duration assets, highly risky because it is difficult for people to reliably see far into the future; at the same time, they appear expensive, and the holder base is not solid.
A Question Raised by My Research Team on This Topic
In a recent meeting, a member of my research team asked me: Why do you think it is wrong for the market to be configured this way today? How do you know that the lack of diversification in today’s market is not for good reasons? For instance, some investors may believe that expected returns on AI stocks will be extremely high; or that when an industry occupies such a high proportion of total market cap, this index concentration will naturally occur; or that when an industry is receiving a lot of enthusiastic support, many investors will buy these stocks without making smart and reliable calculations about what future profits will look like and how those profits should be reflected in prices.
My Answer
There are various reasons for price increases, and not all of these reasons are good. Some investors contemplate the price and drive it higher because they believe it is still attractive relative to the fundamentals; some long-term holders own these stocks because they recognize it as a great new technology and see the rise in stock prices as confirmation that they are good stocks; and some investors have index exposure, which passively gives them a large weight in these stocks. In my view, you can grapple with these issues to decide what you want to do; or you can realize that you don’t need to grapple with this issue, because you simply do not have enough information to confidently place a bet. You can easily say: "I don’t know enough to place a bet." And then not place a bet.
What gets people in trouble is assuming they must form a viewpoint and believing that their viewpoint is valuable; but the more likely scenario is that they cannot form a sufficiently reliable and worthwhile viewpoint to base their bets on.
Footnote: To clarify, I am not suggesting avoiding bets. Moreover, you cannot avoid making bets because you have to put your money into some investment or cash. Most people perceive cash to be the lowest-risk investment, but in the long term, it is almost certainly the worst investment. I suggest that even if you do not have a tactical view on which market is good or which is bad, you should know how to spread your bets well. The way to achieve this is to have a well-balanced strategic asset allocation portfolio and hold it when you lack sufficient confidence for tactical views about betting. But that is a topic for another time.
Thus, I believe: Knowing what you do not know allows you to decide when not to bet, and knowing what you do know enables you to decide when to bet, is equally important.
In simpler terms, I believe in the following principle: Because it is generally difficult to know enough information to justify a concentrated bet, the best approach is to hold a diversified portfolio composed only of your most confident, uncorrelated bets, and engineer this portfolio to the risk level you wish to undertake. This is my "investment holy grail."
At this moment, considering the current set of conditions, I do not believe anyone knows clearly enough what will happen next in this technology-driven market to place a huge and concentrated bet. In my view, avoiding concentration and maintaining diversification is the best way to respond to this state of "not knowing." I know this contradicts the theory you might read in textbooks. Textbooks essentially say that markets are efficient, so you should “trust the market.”
In summary, the current market is exceptionally concentrated and revolves around a revolutionary new technology. This fact should remind us: do not conflate your excitement about new technology with the attractiveness of the new technology stocks themselves; and do not throw caution to the wind by holding a set of high-risk, high-correlation concentrated bets. Especially when we can achieve equally attractive returns with much lower risks through smart diversification, we should certainly avoid doing so.
Appendix: I will not share my specific holdings or tactical views with you because I do not want to be your investment advisor. However, I will soon share some key perspectives behind these views, including my bubble indicator readings and the logic behind them.
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