The Pros and Cons of Ray Dalio's All Weather Portfolio

Ray Dalio’s All Weather Portfolio

The average investor has never heard of the All Weather portfolio until Tony Robbins released the book, “Money, Master the Game: 7 Simple Steps to Financial Freedom”. They definitely didn’t know who Ray Dalio was. However, the All Weather Portfolio has been gaining traction ever since because of its simplicity and good performance.

The reason for this interest in Dalio is because of performance. During the 2008 market crash, the All Weather Portfolio lost only -3.93% versus the S&P 500’s -37% loss. For people that lost almost half their investments in 2008, this is a huge deal.

So, what is the All-Weather Portfolio?  It simply involves buying a portfolio of index funds with a specific percentage in five different asset classes. These asset classes are stocks, long-term bonds, intermediate bonds, commodities, and gold.

As with all investments, deciding to invest in a portfolio like All Weather, a detailed analysis of the approach must be done. To help with that analysis, here are the key pros and cons you should consider.

Pros of the All-Weather Portfolio

Investors are their own worst enemies. In fact, investors rarely stick to one strategy long enough to let the investments do their job. That is why a strategy like the All Weather Portfolio can be a good thing. It gives investors a solid strategy that takes away the decision making and simply dictates what to buy.

Pro #1: Equal Risk in Four Different Economic States

According to Dalio, one of the key benefits of the All Weather portfolio is it helps manage risk by performing well in four different economic states. In other words, portfolio risk is managed no matter what the economy is doing. The four economic “seasons” that impact asset prices are:

1. Rising Growth
2. Falling Growth
3. Rising Inflation
4. Falling Inflation

Stocks, bonds, gold, and commodities all behave different depending on each of the four seasons. In a rising growth and inflation environment, stocks and commodities will perform well while gold and bonds will not.

Alternatively, when economic growth is falling stocks will perform poorly and bonds and gold will typically do better. The All Weather portfolio – with the five asset classes presented above – takes care of economic risk for each of these scenarios.

Pro #2: Holds Asset Classes with Low Correlation

Another key benefit of the All Weather portfolio is that it holds assets that are loosely correlated. Like the pro explained above, this pro is all about how the investor manages portfolio risk.

Most investors agree with the term, “Don’t put all your eggs in one basket”. The All Weather portfolio looks to spread the risk out over different types of assets so that when one asset falls in price, at least one of the other assets grows in value. If a portfolio holds all equities and the stock market dives, then an all equity portfolio is going to go down right with it.

However, if a portfolio holds both stocks and bonds when the equity market drops, the bond holdings protects the portfolio and will not lose as much money. In fact it can actually make money. To illustrate this point, have a look at this chart from tastytrade about the inverse correlation between stocks and bonds:

For example, in October 2014 when the S&P 500 dropped substantially, bonds headed higher. An investor who was only in stocks saw larger loses than a portfolio that also held bonds. This low correlation helps the All Weather portfolio temper losses

Pro #3: Protects Investors from Their Emotions

Emotions have a huge impact on investment returns. In fact, people can do really dumb things because of emotions. This chart from BlackRock highlights this:

Imagine you sold all of your investments in 12/01 when you were panic stricken and defeated. You would have sold at the exact bottom of the market and missed out in one of the biggest market moves in history. Or inversely, imagine you got so euphoric around 12/06 that you went all in on equities only to lose a substantial amount in a fast and painful downdraft.

Ray Dalio’s All Weather helps investors avoid these poor emotional responses by providing good performance with low volatility (swings in the returns). Here are some key stats from recent backtests I have talked about before:

• 9.7% annual returns
• Made money 86% of the time
• Average loss of just 1.9%
• Worst loss was -3.9%
• Volatility of only 7.6%

The investor is not put in a situation because losses are limited and the portfolio has low volatility.  They don’t have an opportunity to become panic stricken or euphoric, forcing them to make short-term decisions that have a negative impact on long-term performance.

Cons of the All-Weather Portfolio

All investment strategies have negatives that must be considered before making an investment in them. It is very easy to get caught up in the positives, especially if the recent performance of the strategy has been solid. Here are three cons that any investor should consider before jumping into Dalio’s All Weather Portfolio.

Con #1: Lower Returns than the S&P 500

Volatility and risk management aside, if an investor can simply buy the S&P 500 and earn returns that beat the All-Weather Portfolio then that must be considered. An investor who used the All-Weather Portfolio earned a 9.7% annual return between 1984 and 2013 (see stats above). That sounds like a good return.

However, when compared to the S&P 500’s return for that same period, it does not sound as good. During that same period between 1984 and 2013, the S&P 500 managed to earn an annualized return of 11.1%.

Here is what that means for a $50,000 investment. $50,000 invested in the All Weather Portfolio in 1984 grew to approximately $625,000 by 2013. Alternatively, $50,000 put into the S&P 500 in 1984 grew to over $1,060,000. That is $435,000 more. Even with the reduced risk of Ray Dalio’s All Weather portfolio, that is a big difference.

Con #2: Risky Bond Allocation

The second con of Dalio’s All-Weather Portfolio is the high allocation to bonds. As stated earlier, one of the pros of the portfolio is the overall allocation to low correlation assets and investments in asset classes that perform differently in different economic cycles. However, with over 55% of the portfolio in bonds an investor may be taking on too much risk in the current low interest rate environment.

Bond prices rise when interest rates fall, and prices fall when interest rates rise. This is important because we are in a record low interest rate environment. This has been good for bonds and the All Weather portfolio in recent years.

This chart from Forbes shows just how low interest rates are right now:

The risk with Dalio’s All Weather Portfolio is that with current interest rates at low levels, we could see rates rise over the next number of years. This means bond prices could fall dramatically hurting the portfolio’s performance. Stock, gold, and/or commodity prices could rise to offset those loses, however with 55% of the portfolio in bonds there is still a high risk to the portfolio.

Conclusion

In the world of hedge funds, one of the best know names is Ray Dalio. Dalio’s advice to investors, given intense airtime through self-help guru Tony Robbins’ book, is to invest in the All Weather Portfolio that helps to provide solid returns with lower risk.

As with all investment strategies, there are both pros and cons. Understanding these positives and negatives is important when ultimately deciding where to invest. The All Weather Portfolio must be invested in for the long-term (at least 10+ years) to be effective so the above pros and cons should all be considered very carefully.

 

What do you think of the All-Weather Portfolio? Would you use it? Do you prefer less volatility with lower returns or more volatility with higher returns?