Ray Dalio: The Light of the Grand Investment Cycle

Introduction: This article is Chapter 2 of Ray Dalio's book *Principles for Dealing with the Changing World Order*, specifically addressing how to configure an investment portfolio within the framework of the Big Cycle.

Dalio uses real historical data to reveal a disturbing fact: in the past century, the wealth of seven out of ten major powers was nearly wiped out at least once—and most investors have never studied this history. At a time of increasing friction in the global order, the reference value of this analytical framework far exceeds that of typical macro commentary.

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Last week, I shared a chapter from my 2021 book *Principles for Dealing with the Changing World Order*, detailing the classic signals and evolutionary processes to watch for during the breakdown of the world's geopolitical order in what I call the "Big Cycle." The article was very popular, receiving over 75 million views, with many asking what this means for investing.

Due to the high volume of inquiries, I am now sharing the next chapter from the book—*Investing in the Big Cycle*—with everyone. I believe it is helpful for the current investment perspective. You can read the full chapter below.

Additionally, since many are interested in my investment principles, I will be sharing them over the coming weeks. If you wish to receive notifications for these releases, please subscribe to my newsletter *Principles Perspectives* or sign up for email alerts.

My strategy for dealing with life and my career is to try to figure out how the world works, develop principles for dealing with it accordingly, and then position myself. The research I share in this book was done for that purpose.

Naturally, when I review everything covered up to this point, I think about how to apply it to investing. To feel confident that I'm doing well, I need to know how my approach would have performed in history. If I can't confidently explain what happened in the past, or at least don't have a strategy for dealing with what I don't know, I consider that a dangerous oversight.

As my research from the past 500 years to the present reveals, there have been big cycles of wealth and power accumulation and loss throughout history, with the biggest contributing factor being the debt and capital market cycles. From an investor's perspective, this can be called the "Big Investment Cycle." I believe it's necessary to fully understand these cycles to tactically move or diversify a portfolio to protect against them or profit from them. By understanding these cycles and ideally judging where countries are within their cycles, I can do that.

In my roughly 50-year career as a global macro investor, I have discovered many universal truths across time and geography that form my investment principles. While I won't delve into all of them here—I'll discuss most in my next book, *Principles for the Economy and Investing*—I want to convey one important principle.

All markets are primarily driven by four factors: growth, inflation, risk premiums, and discount rates.

This is because all investments are essentially an exchange between a one-time payment today and future payments. Future cash payments are determined by growth and inflation; how much risk investors are willing to take relative to holding cash is the risk premium; and what those future payments are worth today—their "present value"—is determined by the discount rate.

Changes in these four determinants drive changes in investment returns. Tell me how each of these four factors will evolve, and I can tell you how investments will perform. Understanding this allows me to know how to connect what's happening in the world with what's happening in the markets, and vice versa. It also shows me how to balance my investments so that the portfolio is not biased toward any particular environment, which is precisely the method for achieving good diversification.

Governments influence these factors through fiscal and monetary policies. Therefore, the interaction between what governments want to happen and what actually happens is what drives the cycles. For example, when growth and inflation are too low, central banks create more money and credit growth, generating purchasing power, first leading to faster economic growth, and then, with a lag, inflation also rises. When central banks restrict money and credit growth, the opposite happens: both economic growth and inflation slow down.

There is a difference between what central governments and central banks do to drive market returns and economic conditions. Central governments decide where the money they use comes from and where it goes because they can tax and spend, but they cannot create money and credit. Central banks can create money and credit but cannot decide where in the real economy that money and credit go. The actions of central governments and central banks affect the buying and selling of goods, services, and investment assets, pushing their prices up or down.

For me, each investment asset reflects these drivers in its own way, consistent with the logic of its impact on future cash flows. Each investment asset is a building block of a portfolio; the challenge is to combine them rationally considering these factors.

For example, when growth is stronger than expected, all else being equal, stock prices may rise; when both growth and inflation are higher than expected, bond prices may fall.

My goal is to combine these building blocks into a well-diversified portfolio that is tactically tilted based on world events that are happening or will happen, affecting these four drivers. These building blocks can be broken down by country, by environmental preference, all the way down to the industry and individual company level. When this concept is applied to a balanced portfolio, the effect is as shown in the chart below. It is through this lens that I examine historical events, market history, and portfolio behavior.

I know my approach differs from that of most investors for two reasons. First, most investors don't look for analogous periods in history because they believe history and past investment returns are largely irrelevant to them. Second, they don't view investment returns through the lens I just described. I believe these perspectives give me and Bridgewater a competitive advantage, but whether to adopt them is up to you.

Most investors set expectations based on their own lifetime experiences; a smaller, more diligent group looks back in history to see how their decision rules would have worked in the 1950s or 1960s. Not a single investor I know, nor a single senior economic policymaker I know—and I know many, including the best—has an excellent understanding of what happened in the past and why. Most investors who look at longer-term returns view the returns of the US and UK (the countries that won World War I and World War II) as representative data.

That's because not many stock and bond markets survived after World War II. But these countries and periods are not representative because they suffer from survivorship bias. Looking at US and UK returns is looking at uniquely fortunate countries during the best part of the Big Cycle. Not examining what happened in other countries and earlier periods creates a distorted perspective.

Reasoning logically from what is known about the Big Cycle, when we extend our view forward a few decades and examine what happened in different places, we get a startlingly different perspective. I will show this because I think you should be aware of it.

In the 35 years before 1945, nearly all wealth in most countries was destroyed or confiscated; in some countries, when capital markets and capitalism collapsed along with other aspects of the old order, many capitalists were killed or imprisoned, stemming from anger towards them.

If we look back over the past few centuries, we see such extreme boom/bust cycles occurring regularly—periods of capital and capitalist prosperity (like the Second Industrial Revolution and Gilded Age in the late 19th and early 20th centuries) followed by transition periods (like the 1900-1910s with increased internal conflict and intensified international competition for wealth and power), leading to periods of great conflict and economic depression (similar to those that occurred between 1910 and 1945).

We can also see that the causal relationships behind those boom and bust periods are more similar today to the depression and restructuring periods at the end of the cycle than to the early prosperity and building periods.

My goal is simply to see and understand what happened in the past and then do my best to show it to you. That's what I will now try to do. I will start from around 1350, although the story begins long before that.

The Big Cycle of Capitalism and Markets

Before around 1350, interest-bearing loans were prohibited by Christianity and Islam—and within Jewish communities by Judaism—because they caused serious problems: human nature led people to borrow more than they could repay, creating tension between borrowers and lenders, often leading to violence. Due to the lack of lending, money was "hard money" (gold and silver). About a century later, during the Age of Exploration, explorers traveled the world, collecting gold, silver, and other hard assets to accumulate more wealth. This was how the greatest wealth was accumulated at the time. Explorers and their financiers split the profits, an effective incentive-based system for getting rich.

The alchemy of lending as we know it today was first created around 1350 in Italy. Lending rules changed, and new types of money were created: cash deposits, bonds, and stocks, in forms very similar to what we know today. Wealth became promises to pay money—what I call "financial wealth."

Think about the enormous impact of the invention and development of bond and stock markets. Before that, all wealth was tangible. Think about how much more "financial wealth" creating these markets created. To imagine the difference, consider: how much "wealth" would you have now if promises of future payments from your cash deposits, stocks, and bonds didn't exist? You would have almost nothing, you would feel bankrupt, and you would behave differently—for example, you would accumulate more savings in tangible wealth. That's roughly what it was like before cash deposits, bonds, and stocks were created.

With the invention and growth of financial wealth, money was no longer constrained by its link to gold and silver. With fewer constraints on money, credit, and purchasing power, it became common practice for entrepreneurs with good ideas to start companies, borrow, and/or sell shares in their companies to get the funding they needed. They were able to do this because promises to pay became money in the form of ledger entries.

Around 1350, those who could do this—most famously the Medici family in Florence—could create money. If you could create credit—say, five times the actual money (which banks could do)—you could generate a lot of purchasing power, so you no longer needed as much of other types of money (gold and silver). The creation of new types of money was, and still is, a form of alchemy. Those who could create and use it—bankers, entrepreneurs, and capitalists—became very wealthy and powerful.

This process of expanding financial wealth has continued to the present day, with financial wealth becoming so large that hard money (gold and silver) and other tangible wealth (like real estate) have become relatively unimportant. But of course, the more promises exist in the form of financial wealth, the greater the risk that these promises cannot be kept. This is the cause of the classic big debt/money/economic cycle. Think about how much financial wealth exists relative to real wealth, and imagine you and others holding financial wealth actually trying to convert it into real wealth—i.e., sell it and buy something. It's like a bank run. It can't happen. The value of bonds and stocks is too large relative to what they can buy. But remember, under a fiat money system, central banks can print money to provide the currency needed to meet demand. This is a universal truth across time and geography.

Also remember that paper money and financial assets (like stocks and bonds), which are essentially promises to pay, aren't very useful in themselves; what's useful is only what they can buy.

As discussed in detail in Chapter 3, when credit is created, purchasing power is created along with the promise to pay, so it is stimulative in the short term and depressive in the long term. This creates cycles. Throughout history, the desire to obtain money (by borrowing or selling stock) has existed in a symbiotic relationship with the desire to store money (by lending or buying stock as an investment). This leads to growth in the form of purchasing power, eventually producing far more promises of payment than can be delivered, and crises of broken promises in the form of debt-default depressions and stock market crashes.

At such times, bankers and capitalists were literally and figuratively hanged, vast amounts of wealth and lives were destroyed, and large amounts of fiat money (money that can be printed and has no intrinsic value) were printed to try to alleviate the crises.

The Complete Picture of the Big Cycle from an Investor's Perspective

While it would be too burdensome for me and you to review all relevant history from 1350 to the present, I will show you what it would have been like if you had invested starting in 1900. But before that, I want to explain how I view risk, as I will emphasize these risks in what follows.

In my view, investment risk is the inability to earn enough money to meet your needs, not volatility as measured by standard deviation—though the latter is almost exclusively used as the measure of risk.

For me, the three biggest risks most investors face are: the portfolio failing to provide the returns needed to meet spending needs, the portfolio being destroyed, and most wealth being confiscated (e.g., through high taxes).

While the first two risks sound similar, they are actually different because it's possible to have an average return higher than needed while simultaneously experiencing one or more devastating large losses.

To gain perspective, I imagine being dropped into 1900 and seeing how my investments would have fared in each decade since then. I chose to examine the 10 most powerful countries in 1900, skipping less developed countries that were more prone to bad outcomes. In reality, any of these countries was or could have become a great wealthy empire; they were all reasonable places to invest, especially when one wanted a diversified portfolio.

Seven of these 10 countries experienced at least one episode where wealth was almost completely destroyed, and even those that didn't see wealth destroyed experienced decades of terrible asset returns that nearly led to financial ruin. Two great developed countries—Germany and Japan, which one might easily have bet on to be winners at times—saw almost all their wealth destroyed in the two world wars, with many lives lost. I have seen many other countries with similar outcomes. The US and UK (and a few other countries) were particularly successful cases, but even they experienced periods of massive wealth destruction.

If I hadn't examined returns from the period before the new world order began in 1945, I wouldn't have seen these destruction periods. If I hadn't looked back at 500 years of global history, I wouldn't have seen this happen repeatedly almost everywhere.

The numbers shown in the following table are the annualized real returns for each decade, meaning losses over the entire decade are roughly eight times the shown number, and gains are roughly 15 times the shown number.

Perhaps the following chart provides a clearer picture, showing the proportion of major countries with a 60/40 stock/bond portfolio that suffered losses over five-year periods.

The following table details the worst-case scenarios for investing in major countries. You'll notice the US does not appear on this table because it is not among the worst cases. The US, Canada, and Australia were the only countries that did not experience sustained loss periods.

Naturally, I think about how I would have coped if I were living through those periods. I can say with certainty that even if I had seen the signs of what was coming that I convey in this book, I would never have had the confidence to predict such terrible outcomes—as mentioned, seven out of ten countries saw their wealth wiped out. At the beginning of the 20th century, even those looking back at the past few decades would never have foreseen this, because based