Wednesday, 7 March 2012

Luck or skill? Ray Dalio of Bridgewater

Do investors like Warren Buffett succeed through luck or skill? The statistical argument is that such success cannot be distinguished from luck so therefore we cannot believe in skill. Yet ... when we encounter successful people in more tangible pursuits like sports or music, we don't say they are just lucky.

The other day I came across Principles, the exposition of what uber-rich investor Ray Dalio believes and lives by. Dalio is the founder of Bridgewater Associates, the world's biggest hedge fund according to Wikipedia. (Interestingly, Bridgewater manages some of our pension money as one of the Canada Pension Plan Investment Board's private investment partners). Principles isn't flowery imaginative writing - just plain, matter-of-fact, direct statement - but what it says rings true. It also isn't about investing principles he follows - that may come later he says. Though meant primarily as a management bible and indoctrination tool for new employees at Bridgewater, there is much value for self-reflection on what it takes to be successful e.g. "everyone has weaknesses. The main difference between unsuccessful and
successful people is that unsuccessful people don’t find and address them, and successful people do".

Dalio evidently (e.g. see John Cassidy's Mastering the Machine in the New Yorker of last July) lives by his principles with a ruthless and implacable discipline. It's the same as in any other human endeavour. To become highly successful, let alone the best, requires enormous unstinting effort.

Interesting is his take on ability since most people including me believe that talent must be there too. His reply is "... if you are motivated, you can succeed even if you don’t have the abilities (i.e., talents and skills) because you can get the help from others". In investing terms, that could mean using an advisor but then Dalio's principle 187 kicks in - "Have good controls so that you are not exposed to the dishonesty of others and trust is never an issue. A higher percentage of the population than you might imagine will cheat if given an opportunity, and most people who are given the choice of being “fair” with you and taking more for themselves will choose taking more for themselves." Or it could mean a person should take the passive index ETF route where talent and ability aren't required at all.

Dalio unintentionally provides support for the argument that there really is investing ability. First, as he says in principle 31,"People who have repeatedly and successfully accomplished the thing in question and have great explanations when probed are most believable. Those with one of those two qualities are somewhat believable; people with neither are least believable". The phenomenal success of Bridgewater is a hefty track record and this book is a pretty good explanation.

Second, in footnote 38 on page 21 he says "Luck—both good and bad—is a reality. But it is not a reason for an excuse. In life, we have a large number of choices, and luck can play a dominant role in the outcomes of our choices. But if you have a large enough sample size—if you have large number of decisions (if you are playing a lot of poker hands, for example)—over time, luck will cancel out and skill will have a dominant role in determining outcomes. A superior decision-maker will produce superior outcomes". Investing is very much an activity where there really is luck or true uncertainty at play so one cannot expect always to be correct, no matter how much data one collects and analyzes. Now, it is true that the world's biggest hedge fund may have got there merely by gathering assets and snowing all those giant pension funds about actual investment performance but there is some direct performance evidence cited in Wikipedia.

As the ancient Greek Aeschylus said "Call no man happy till he is dead". Dalio's investing prowess is only as far away as the next market shift that he has not anticipated which runs contrary to his investments. He does claim not to be too concentrated and is aware of the danger per principle 197 "make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil ... knowing what you don’t know is at least as valuable as knowing" and principle 195 "Constantly worry about what you are missing. Even if you acknowledge you are a “dumb shit” and are following the principles and are designing around your weaknesses, understand that you still might be missing things". The New Yorker article also says he deliberately does not make any concentrated bets to avoid the possibility of being wiped out.

A blowup by Bridgewater / Dalio would no doubt make the skeptics happy, strangely including blogger Pension Pulse. I prefer to think investing is like sports - champions do exist because they are better than everyone else at the time but they all have their day.

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