When the co-CIO of the world's largest hedge fund talks, we listen.
Legendary investor Ray Dalio's Bridgewater Associates didn't get to manage circa US$150 billion in funds under management without holding at least some authority on investing and portfolio management.
And given the recent volatility in the S&P/ASX 200 Index (ASX: XJO) – spurred by rising US Treasury yields and a rotation out of growth-type stocks into defensives – many investors might be wondering just how much weight they should have in cash moving forward.
Here's what Ray Dalio had to say on the matter during his address to the 22nd annual UBS Greater China Conference that started on Monday.
Cash is a lazy asset that's susceptible to inflation risk
Even amid the market volatility in global stocks, Dalio advocates that investors should keep exposure to cash light.
The hedge fund giant explained that recent quantitative easing (QE) programs from central banks around the world — the US in particular – have contributed to record levels of country debt to GDP.
This creates a vicious cycle where central banks must flood the economy with more liquidity to keep servicing the ever-soaring debt load.
As such, this has resulted in "significantly negative real rates of cash and negative real rates of bonds". For reference, a 'real' rate is generally adjusted for inflation, whereas 'nominal' rates exclude inflationary data.
Many investors and fund managers like Ray Dalio advocate thinking in terms of real rates/returns, given they paint a more accurate picture by factoring in all the market mechanics.
Plus, Dalio argues that central banks around the world are stuck between a rock and a hard place following their QE efforts in 2020/21.
Dalio says that "if there was a rise in rates to equal the inflation rate or the long-term returns of asset classes, assets would go down and it would be a problem – they'd shut off everything".
Given these points, the legendary investor and "new world order" theorist submits that investors must "stop viewing cash as a safe investment".
Typically, according to Dalio, investors think cash is safe because it doesn't present with the same volatility as stocks or derivatives for instance.
"The mindset needs to change," Dalio says, to one "in which everybody looks at real returns. In other words, inflation-adjusted, because you want buying power".
Holding cash will see investors inevitably lose their buying power as the 'invisible tax' of inflation will eat into the real returns and/or purchasing power on the asset class.
Imagine if inflation is at 3% net year, and then 3% again the year after that. What $100 buys you today will not be the same as the next 2 years in this scenario. Imagine we wanted to buy a $100 jumper. As prices increase by 3%, the $100 jumper will cost $103 next year then $106.09 the following period. Our $100 note has lost some of its value.
That is what Dalio refers to when speaking of a loss of buying power. It's another way of stating cash is susceptible to the risk of inflation, as too are cash-producing assets like dividend stocks.
That's precisely why one should try to store buying power, Dalio says. "If you're holding an asset that has very little return … and is not volatile, but loses to inflation that could be 5 per cent a year", then there's a lot of inflation risk which must be considered.
Diversification – the only free lunch
Meanwhile, Dalio also advocates that investors stay light in cash due to the benefits achieved through proper diversification within and across asset classes.
Diversification – which has been touted 'the only free lunch' in finance – doesn't just mitigate risks. It also helps to generate more sources of value and/or return.
The hedge fund co-CIO notes that he is keeping a close eye on 3 or 4 themes in his investment reasoning. These include: "the country or the place, the company or the individual, earning more than they're spending and financially sound, with a good balance sheet".
Following a similar approach means investors can remain "highly diversified" and are able to "take tactical moves from those [allocations]".
As such, remaining too concentrated in cash goes against the principles of diversification and, based on Dalio's commentary, would ultimately hurt a portfolio's alpha potential with more risk.
Dalio's concluding remarks note that "we're all interested in how the world's order is changing because that tells us where the risks and opportunities are, and that relates not only to China and the US".
In summary, Dalio says stay light on cash, think in terms of "real rates of return" and remain diversified across asset classes. Most importantly, he says, is to stop thinking of cash as some safe haven asset that has no risk involved. He says this simply isn't true.
