Original Title: Investment Principles: What Should You Do Under Existing Conditions?

Original Author: Ray Dalio, founder of Bridgewater Associates

Translation: Peggy, BlockBeats

Editor's Note: Against the backdrop of AI giants continually boosting the US stock market index and increasing market concentration, Ray Dalio reexamines a classic question in this latest note: When a revolutionary technology is changing the world, how should investors allocate their assets?

Dalio's key reminder is that technological progress itself does not equate to equivalent attractiveness of related stocks. Major technological cycles in history have often gone through excitement, crowding, volatility, and shakeouts. Even companies that have been long-term winners like Microsoft and Apple have experienced significant pullbacks during these cycles. Today's AI industry faces multiple uncertainties such as overinvestment, intensified competition, geopolitical issues, tax policies, anti-AI sentiments, and the disruption of next-generation technologies.

The most important point of the article is not to judge whether AI will change the world, but to discuss how investors should deal with a "highly concentrated" market structure. Dalio believes that as a few tech companies occupy an increasingly high weight in the index, investors need to be alert to whether they unintentionally hold a highly correlated, high-risk concentrated exposure. Instead of continuing to chase a few leaders, the truly more robust approach is to build a diversified portfolio composed of high-quality, low-correlated assets and adjust the volatility level based on their risk tolerance.

In his view, knowing what you don’t know is as important as determining what you know. Faced with the current market environment driven by AI, with high valuations and concentrated risks, investors should not translate their excitement about new technology directly into a concentrated allocation to a few AI stocks. Diversification is the "investment holy grail" that Dalio sees as transcending this technological cycle.

The following is the original text:

This note discusses: how you should play the game of investing in the current environment.

Imagine that you are playing a game like bridge, poker, chess, or Go, it's your turn to make a move, and there is a computer next to you that can assess the situation and suggest the next move to you. To me, investing is like this. Whether or not you have a computer to assist you, I believe you should:

Based on the current state of the board, ask yourself what your next move should be. In other words, you need to act based on the existing characteristics of the market and the various forces influencing it.

I have been playing this investment game for a long time. At this stage, my goal is to convey how I will play this game; furthermore, I also aim to create a platform where people can explore the investment game in the way they want, learn, backtest how they would have done in the past, and truly excel at it. I believe that there are right and wrong ways to play the hand you've been dealt. So when faced with a scenario like XYZ, you should ask yourself, "How should I bet in this situation?" and be able to provide a good answer.

Now, I want to share with you my view of the current market characteristics, what I think should be done, and what I am actually doing.

How to Respond to the Current Environment

What are the most important environmental factors at the moment? How should one bet under these factors?

In my view, and likely in the view of many, the market environment we are currently in is: an industry driven by significant new technology, primarily AI, where only a few companies dominate the market trend. These companies hold a high percentage of the overall market capitalization and are having a massive impact on the market and economy. All such periods share a common theme: a lot of excitement, uncertainty, and volatility centered around the new technology industry, transmitting to the global stock market through this industry. Therefore, the volatility and uncertainty around this industry are crucial.

Additionally, there are uncertainties related to other major drivers. I refer to these drivers as the "Five Forces": 1) What is happening with debt and currency; 2) What is happening with political and social issues that may have a significant impact on market factors like taxation and other politically driven market factors; 3) How do geopolitical factors affect the market, e.g., wars; 4) What natural forces are at play; 5) What is happening with new technology. I will input these conditions into my investment system to consider how to bet in these environments, while I will also independently consider where to place my bets.

When thinking about how to bet in these environments, the most important question is: What kind of choice do you really want to make? a) Betting heavier on new technology compared to broad stock indices like the S&P 500, or overallocating to this new industry, or overallocating to the best few companies in that industry; b) Keeping your exposure roughly around index weights; or c) Diversifying out of this concentration?

Almost everyone wants to find the best investment and is willing to strive for it. Currently, a new technology seems to be changing almost everything. However, history shows that at this stage of the cycle, most people fail because they have placed a large percentage of their chips on the stocks of a few leading technology companies. There is a logical set of reasons behind this, and it has always evolved this way in the past. Although this time AI technology is indeed unique, many similarly "unique" new technologies have appeared in history, serving as analogies and references. People should study these cases; if they choose to ignore them, they must be able to explain well why this time is different.

The Risk Is Undoubtedly High

All past significant new technology cases have unfolded in similar ways due to the same logical reasons. High risk and immense uncertainty are inherent features of these new technology companies. Taking a look at the performance of these companies in similar environments in history, even the best revolutionary new technology companies that have thrived long-term, such as Microsoft and Apple, have also suffered significant setbacks at similar stages of development. Moreover, at the early stages of these new technology companies, rather than in hindsight, it is not easy for people to judge which companies will succeed and which will fail, such as IBM. If you observe all these cases, you will see that significant new technology companies inherently have a highly uncertain future.

For example, they either overinvest or underinvest. The reason is that if they do not invest enough to win the competition, they will undoubtedly lose. However, they cannot accurately know what will happen in the future to judge whether they have overinvested. The cost of both overinvestment and underinvestment is high.

Furthermore, they are also unable to foresee all changes accurately, including exogenous changes such as monetary tightening, wars, significant tax changes, which can impact them. Therefore, they all go through intense up and down cycles: first exciting investors, then scaring them and washing out the weak investors, ultimately causing the market to experience exaggerated fluctuations. Moreover, just as these new technologies and new technology companies have disrupted predecessors, most of them will eventually be disrupted by newer technologies and newer technology companies in ways we cannot imagine in advance. Therefore, we should also consider whether the same risks will occur with the current new technologies and tech companies. The impact of quantum computing is one of the known known risks. So, what about the risks that have not yet been imagined?

What about the risks brought by competitors? For example, China is producing and distributing AI technology, and Chinese policymakers have a fundamentally different view of the economy and AI. We are in the midst of a new technology war, and world leaders believe they must win this war. Their understanding of AI and its impact on the economy and human welfare will prompt them to provide this technology for free or at a low price because it has enormous productivity gains and can raise living standards overall. In their view, the overall benefits of many people using these new technologies are more important than profit. I believe they will compete in the international market as they have in automobiles, solar panels, batteries, and many other products.

The current environment is reminiscent of many historical cases that provided valuable lessons. I can't help but think of how, at the end of the Dutch Empire and the beginning of the British Empire, Britain defeated the Netherlands in the shipbuilding industry and other key sectors. Furthermore, there is a geopolitical conflict surrounding Taiwan, which should at least make us consider one possibility: as a geopolitical tool of war, China may prevent chips from flowing out of Taiwan. AI stocks also face other risks, such as the risk of wealth taxes and other tax increases, which may force a large sell-off by holders of significant wealth in these stocks; as well as the rising anti-AI sentiment, which could limit the space for companies to advance technological development.

I could list more worrisome things for you, but I could also list an equally long list of the huge opportunities that AI will create, and that is where I want to place my bets. I am not saying how these risks will necessarily play out, nor am I saying that one should not bet on AI companies. I am just saying that there is undeniably a high level of concentrated risk in the market, and people should be aware of how to deal with such an environment. Based on my research into all similar cases and the logical reasons therein, I am convinced that the risk is high, and the best way to address this environment is:

Embrace Diversification

You might be familiar with my mantra of "diversification." My "investment Holy Grail" is to strive to hold 15 high-quality, uncorrelated, and risk-balanced investments. In other words:

An investment portfolio comprised of high-quality bets that are sufficiently diversified will outperform a single concentrated bet. Its risk-return ratio is higher and can achieve a better return at the same risk level through engineering. The more the risk in the market is concentrated in one area, the more one should diversify; especially when the market is being driven by revolutionary new technology, as this technology itself will create significant uncertainty.

This is not an opinion; it is a mathematical certainty. For example, if I take an investment with a risk-return ratio of 0.3, assuming a return of 6% and a standard deviation of 18%, which is a common assumption for stocks; then, if I hold 5, 10, or 15 uncorrelated investments, I can achieve the same 6% return, but the risk measured by standard deviation will decrease to 8%, 6%, and 5%, respectively. Therefore, by holding 15 high-quality and uncorrelated investments, my risk-return ratio will increase by 4.3 times, from 0.3 to 1.29. If you wish, you can also leverage on this basis to achieve much higher returns at the same risk level. That is a fact.

I have strong confidence in this. The reason comes from my backtesting, the actual returns I have delivered over my over 50-year investment career, and the probabilistic logic within it: excellent bets diversified and adjusted to the volatility one wishes to bear will, in the long run, generate much better returns than the concentrated bets most investors tend to hold. Specifically, through good diversification, one can achieve a better risk-return ratio than any concentrated bet; adjusting it to the risk level one is willing to bear allows for a higher return at the target risk level compared to any other process.

Because I am sharing this approach, it is no longer my "not-so-secret" way of investing. Nevertheless, I rarely encounter investors who think about investment strategy in this way. That is to say, I rarely meet people who truly think from a portfolio construction perspective, considering how a well-structured, diversified bet portfolio would perform differently from just holding a stock of a great company in a new transformative industry. Most people are just thinking about whether these stocks and this industry will perform well and how to bet on them. The performance results of those who think about portfolio construction versus those who do not think can be vastly different. Therefore, I will elaborate more fully on my thoughts on how to do this well at another time.

Based on all these reasons, in the current environment, thinking about how to play your hand well should make one ask oneself: How much concentration should I really have before diversifying?

The Returns Look Low

The high risk is undeniable. Next, I am going to present a potentially mistaken view: the expected future returns look low. My judgment on the expected future returns comes from valuation-related analysis work and my bubble indicator readings: the real return rate of stocks in the next 5 to 10 years seems to be around -5% to -10%, although these numbers carry significant uncertainty. In my view, these stocks are long-duration assets, high-risk because it is challenging for people to reliably see far into the future; at the same time, they seem overpriced, and the holder base is not stable.

A Question Raised by My Research Team on This Topic

At the last meeting, a member of my research team asked me: Why do you think the market is incorrectly allocated in the way it is today? How do you know that today's market lacks diversification not for valid reasons? For example, some investors believe that the expected return of AI stocks will be very high; or when an industry occupies such a high proportion of the total market value, this index concentration would naturally occur; or when an industry is enthusiastically sought after, many investors will buy these stocks without making smart and reliable calculations about what future earnings will look like and how these earnings should be reflected in stock prices.

My Response

There are various reasons for price increases, and not all of these reasons are good. Some investors think about prices and drive prices higher because they believe that the price still looks attractive relative to fundamentals; some investors hold these stocks for the long term because they realize this is a great new technology and see the price increase as confirmation that these are good stocks; and some investors have index exposure, which passively gives them a significant weight in these stocks. In my view, you can get caught up in these questions to decide what you want to do; or you can realize that you don't need to dwell on this issue because you simply don't have enough information to confidently bet. You can entirely say, "I don't know enough to bet confidently." And then not bet.

What gets people into trouble is thinking they must form a view and believing that their view is valuable; but more likely, they can't form a reliable, bettable view.

Footnote: To be clear, I'm not suggesting avoiding bets. Besides, you can't avoid bets because you have to put your money into some mix of investments or cash. Most people consider cash the safest investment, but in the long run, it almost certainly is the worst investment. What I'm suggesting is that even if you don't have tactical viewpoints about which markets are good or bad, you should know how to bet well by diversifying. The way to do this is by having a well-balanced strategic asset allocation mix and holding onto it when you don’t have bettable tactical views. But that's a topic for another time.

So, I believe: knowing what you don’t know and deciding when not to bet is as important as knowing what you do know and deciding when to bet.

In simpler terms, I believe in the following principle: because it's usually hard to know enough to prove concentrated bets are rational, the best approach is to hold only well-diversified bets you have strong confidence in and that are uncorrelated with each other – an engineered portfolio adjusted to the risk level you desire. That's my "Holy Grail of Investing."

At this moment, given the current environment, I don't believe that anyone can be clear enough about what will happen next in this tech-driven market to make a big, concentrated bet. To me, avoiding concentration and maintaining diversification is the best way to deal with this "not-knowing." I know this is contrary to what you might read in textbooks. Textbooks essentially say that the market is efficient, so you should "believe in the market."

In summary, the current market is unusually concentrated and revolves around a revolutionary new technology. This fact should remind us: don’t confuse your excitement about new technology with whether the stocks of those technologies are attractive, and don't give up caution by holding a highly risky, highly correlated concentrated bet. Especially when we can achieve similarly attractive returns at much lower risk through clever diversification.

Postscript: I won't share with you my specific holdings or tactical views because I don't want to be your investment advisor. But I will soon share with you some key perspectives behind these views, including my bubble indicators and the logic behind them.

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