Page 55 - Ray Dalio - Principles
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components and then come up with a plan for managing each
part, using a variety of financial tools, especially derivative
instruments. The most important components to separate were
the profits coming from the core business and those that were
speculative profits and losses coming from price changes. We
would do this to show them what a “risk-neutral” position
would look like, which is to say, the properly hedged position
one would take if one didn’t have a view of the markets. I
would advise them to deviate from this position only when
they wanted to speculate, which they should only do in
measured ways and with full knowledge of the effects it could
have on their core business. This approach was eye-opening
for most of the firms we worked with. It gave them clarity and
control, and yielded them better results. Sometimes they
wanted us to speculate for them, which we would do for a
share of the profits.
This approach to establishing a “risk-neutral” benchmark
position and deviating from it with measured bets was the
genesis of the style of investment management we would later
call “alpha overlay,” in which passive (“beta”) and active
(“alpha”) exposures are separated. The return of a market
(such as the stock market) itself is called its beta. Alpha is the
return that comes from betting against others. For example,
some people outperform the stock market and others
underperform it; they are said to have positive or negative
alpha. With alpha overlay, we were offering a way of making
bets independent of underlying market performance.
Approaching the market in this way taught me that one of the
keys to being a successful investor is to only take bets you are
highly confident in and to diversify them well.
One of our clients in the mid-1980s was Alan Bond, an
audacious entrepreneur who was one of the richest people in
Australia. A self-made man, he was famous for being the first
non-American to win the America’s Cup yacht race in its then
132-year history. Like Bunker Hunt, he eventually bet badly
and was forced to declare bankruptcy. I advised him and his
team on their way up and stayed on through his downfall, so I
watched the tragedy unfold from up close. His was a classic