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
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