What Makes the Prices Change?

As Ray Dalio found when he applied Occam’s Razor to securities markets, there are only four major factors that predictably cause different classes of investments to move in price:

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

If we can build a portfolio of instruments that do well collectively in any of those conditions, then we have some serious protection from the downside of the other instruments.  This has the potential to reduce the volatility of our portfolio greatly.  Notice that these things don’t matter in an absolute sense as much as they do relative to the collective expectations of market participants.  Asset prices already bake in the predicted future conditions.  This is a problem for investors since surprises, by definition, cannot be predicted.

Dalio’s strategy calls for allocating our portfolio by placing a basket of assets in each of the four possible conditions and then allocating money into those baskets based on risk and not dollars.  The amazing thing about this strategy is that we are not attempting to divine the future; rather, we are preparing our portfolios for all possible futures.  In other words, we are dividing our portfolio into four sub-portfolios, one for each of the four types of market conditions.

In a classic white paper, Dalio provides us with a glimpse of the types of instruments that would perform well in each quadrant:

Growth Inflation
Rising      Stocks

Corporate Bonds

Commodities / Gold

Commodities / Gold

TIPS (Inflation Linked Bonds)

Falling     Treasury Bonds

TIPS (Inflation Linked Bonds)

Treasury Bonds


The idea that a normal person with a PC and a lunch break can beat the market is ludicrous.  I suffered under those delusions for a time, but a year of trading minus a lease payment on a BMW worth of commissions left me precisely where I started.  Betting on the direction and magnitude of equity price moves is a sucker’s bet.  There are a few people that can do it consistently, but they are the unicorns.

They are the gold medalists of Wall Street.  They have billions of dollars, hundreds of analysts, and the most amazing technology on the planet.  These unicorns sometimes say what the average investor should do.  Warren Buffett and Peter Lynch are both on record telling us that we are not unicorns, and we should just buy and hold the S&P 500.  They are actually in the minority.  Let’s examine the recommendations of some geniuses.

What the Experts Say Do

(and a “target fund” to show how wrong most of us are)

Security Type David Swensen Ray Dalio Prof. Malkiel Jack Bogle Vanguard Target Retirement 2040
Cash 0% 0% 0% 0% 1.23%
US Stocks (Total Index) 20% 30% 27% 65% 51.13%
International Stock (Developed Markets) 20% 0% 14% 0% 33.17%
Emerging Markets Stock 10% 0% 14% 0% 0%
Speculative Stocks 0% 0% 0% 0% 0%
REITs 20% 0% 12% 0% 0%
Total Bond Index 0% 0% 33% 0% 13.65%
Long-term US Treasuries (20-25 years) 15% 40% 0% 0% 0%
Intermediate-Term Bonds (7-10 years) 0% 15% 0% 35% 0%
TIPS (Inflation Linked Bonds) 15% ? 0% 0% 0%
Gold 0% 7.50% 0% 0% 0%
Commodities 0% 7.50% 0% 0% 0%

Other than the venerable Mr. Bogle, none of our experts adheres to the idea that you should buy the market and hold on for dear life.  Mr. Buffett’s advice is for you to follow Mr. Bogle’s advice.

An interesting aspect of Dalio’s method is that you never adjust for risk tolerance as you get older.  This is because an optimal risk balance is the basis of the portfolio.  We all know that the simplified model presented above doesn’t reflect the business practices of Bridgewater.  I don’t think any investor alive today can consistently match the returns that they do get using tons of leverage and supercomputers.  The simplified version, did, however, return a rate of around 10% when backtested.

My take on this is that younger investors can take on a little risk and perhaps gain some alpha along the way.  Dalio designed the All Weather portfolio for capturing beta, and nothing else.  My version is scaled by age and takes off risk as one approaches retirement age.  Thus, my model is a sort of hybrid between Mr. Dalio’s model and Dr. Malkiel’s model.

If you prefer to forsake alpha and lower volatility, you can adjust your age to the far right column and get very close to the All Weather portfolio of Mr. Dalio.  Note that much of this work has been based on conjecture and the need to bend the rules to mutual funds available to the retail investor.  My method for picking those was a matter of choosing index funds with very low fees, a solid company behind them, and high liquidity.  Vanguard was the hands-down winner.

McKee’s All Weather Allocation

(Expected Volatility Can Be Lowered By Choosing a Higher Age Bracket)

Security Type Age 25 – 30 Age 31 – 35 Age 36 – 40 Age 41 -45 Age 46 – 50 Age 51-55 Age 55+
US Stocks (Total Index) 15% 15% 15% 25% 25% 25% 25%
International Stock (Developed Markets) 5% 5% 5% 5% 5% 5% 5%
Emerging Markets Stock 5% 5% 5% 0% 0% 0% 0%
Speculative Stocks 5% 5% 5% 0% 0% 0% 0%
REITs 12% 12% 12% 12% 6% 6% 0%
Long-term US Treasuries (20-25 years) 18% 18% 18% 18% 24% 24% 30%
Intermediate Term Bonds (7-10 years) 15% 15% 15% 15% 15% 15% 15%
TIPS (Inflation Linked Bonds) 10% 10% 10% 10% 10% 10% 10%
Gold 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50%
Commodities 7.50% 7.50% 7.50% 7.50% 7.50% 7.50% 7.50%
100% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

You can approximate the strategy using the following mutual funds:

Mutual Funds that Meet the Goals of the Strategy

Security Type Mutual Funds
U.S. Stocks VFINX (S&P 500) / VTSMX (Total Market)
International Stock (Developed Markets) DFIEX / VGTSX
Emerging Markets Stock DFEMX
Speculative Stocks PRGTX
Long-term US Treasuries (20-25 years) VUSTX
Intermediate-Term Bonds (7-10 years) VFITX
TIPS (Inflation Linked Bonds) VIPSX / VAIPX
Commodities FCSSX

Note that gold, commodities, and REITs are the hardest elements to find mutual funds for.  Many plan managers simply do not have enough good offerings.  You will need to open a brokerage account to have more options than the high fee stuff that they give you by default (chosen by our betters).

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Last Updated: 6/25/2018

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