Jack Schwager summarizing some of Ray Dalio’s thoughts on diversification and correlation

Dalio is a strong believer in diversification. In fact, he calls the potential improvement in return/risk through the addition of uncorrelated assets the “Holy Grail of investing.” He states that return/risk can be improved by as much as a factor of 5 to 1 if the assets in the portfolio are truly independent.

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Dalio believes that correlation can be a misleading statistic and poorly suited as a tool for constructing a diversified portfolio. The crux of the problem is that correlations between assets are highly variable and critically dependent on prevailing circumstances. For example, typically, gold and bonds are inversely related because inflation (current or expected) will be bullish for gold and negative for bonds (because higher inflation normally implies higher interest rates). In the early phases of a deleveraging cycle, however, both gold and bonds can move higher together, as aggressive monetary easing will reduce interest rates (i.e., increase bond prices), while at the same time enhancing longer-term concerns over currency depreciation, which will increase gold prices. In this type of environment, gold and bonds can be positively correlated, which is exactly opposite their normal relationship.

Instead of using correlation as a measure of dependence between positions, Dalio focuses on the underlying drivers that are expected to affect those positions. Drivers are the cause; correlations are the consequence. In order to ensure a diversified portfolio, it is necessary to select assets that have different drivers. By determining the future drivers that are likely to impact each market, a forward-looking approach, Dalio can more accurately assess which positions are likely to move in the same direction or inversely—for example, anticipate when gold and bonds are likely to move in the same direction and when they are likely to move in opposite directions. In contrast, making decisions based on correlation, which is backward looking, can lead to faulty decisions in forming portfolios. Dalio constructs portfolios so that the different positions have different drivers rather than simply being uncorrelated.