Ray Dalio: The Investing Opportunity of a Generation

Yes, crash was negative, right? One and a half, two percent real rates—terrible! Now cash is relatively attractive.

Ray Dalio is a billionaire and one of the most highly respected investors in the world. He has been investing for 50 years, meaning he knows a thing or two when it comes to investing. In a recent interview, he talked about a shift in the stock market and economy that you need to know about. This shift fundamentally changes the investing landscape.

In this video, we're going to answer three questions: What exactly Ray Dalio is seeing? Why is the shift in the stock market and economy occurring? And finally, how can you make sure you don't miss out on this opportunity? But first, make sure to hit that like button and subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors.

Now let's listen to what Ray Dalio had to say.

"So help us try to understand what's happened. We always talk about the economic machine. We've got the Federal Reserve as part of that machine, of sorts, at least trying to assess what that machine is going to do. You saw what Jay Powell said yesterday. I think we're all trying to make sense of where we really are.

Okay, well, I mean, these things happen over and over again. We're now in the 12th and a half cycle. You know how the cycles work. You're 12 and a half cycles since 1945. 1945 was the New World Order, you know, new monetary system. And you know what happens, so let me take you through it quickly.

You provide, you get a funky economy, weakness, and so on. So what we had, of course, in 2020, with a combination of COVID and then also the move from the right to the left, there was a distribution of wealth. So, how did you do that? Government had to send out a bunch of checks, and the Federal Reserve—where'd the government get the money from? The Federal Reserve lent it.

So we have an imbalance, and of course that put a lot of money in the system. You've got the demand, you've got the cycle—classic cycle, right? Stimulation, credit becomes debt. Then you have inflation, then you have a tightness monetary policy.

And so, where are we? So, we now are in a classic spot where we've got a relatively high real interest rate. Real interest rates went from minus 175 basis points to plus, right? 175 basis points, right? You've got a cash rate that's relatively high. Cash used to be trashy. Crash is pretty active now.

You've got an inverted yield, and then again, you said trash is now more attractive—cash, cash, cash. 'Cash is trash,' is what you used to say. Yes, crash was negative, right? One and a half, two percent real rates—terrible! Now cash is relatively attractive, right? So it's attractive in relation to bonds, it's actually attractive in relation to stocks.

You have the classic movement, of course, as rates go up and money becomes tight. You lose the parts of the economy, the parts of the market that are the bubble parts that needed the cash flow, right? So you're seeing it reflected in, um, not only, you know, long-duration stocks—those that didn't have cash use—so you see the tech stocks come down, all of that come down. You see private equity, you see venture capital because they needed cash—all of that comes down. And then, so you're seeing a very, very, very classic that we've seen—these things for 12—and they were halfway through a 12th or 13th cycle, right?

But what's also happening in that cycle, since 1945, is that we then have the accumulation of a lot of debt and money. Okay? So, we deal with things like the debt ceiling. That's the only matter. Does it matter how much debt we have? And then you have a situation where there used to be a free market supply-demand, but now you've got the Federal Reserve who is now taking it, buying it on the balance sheet. So it's not the supply-demand.

So you've got that dynamic, very, very classically going. I don't think people are paying enough attention to the big cycle. They’re the short-term cycles since World War II. They've averaged about seven, six or seven years, plus or minus about three years. That's what we're in—a classic one of those. But we keep building up the debt.

The last 30 years of investing has been defined by extremely low interest rates. However, things have started to change drastically in recent months. The U.S. Federal Reserve has increased interest rates at the fastest rate ever.

As of the making of this video, the U.S. federal funds rate, a proxy for interest rates in the economy, sits at 4.6 percent, which is the highest interest rates have been in over 15 years and likely have even higher to go.

In order to find a period of time when interest rates were significantly higher, you would have to go all the way back to the late 1980s. For the better part of the last 15 years, not only were interest rates low, they were literally zero percent. This shift from zero percent interest rates up to a more normalized rate environment may not seem like a huge deal to the average person, but this change fundamentally alters the investing landscape.

Let me explain. For the first time in nearly a generation, investors can actually generate a return from cash and what is referred to as cash alternatives, like short-term U.S. treasury bonds. Speaking of short-term treasuries, that is a great segue to the sponsor of today's video—Public.

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Now, let's get back to the video. Higher interest rates fundamentally change the way investors can approach investing.

I'm going to demonstrate what I mean by using a teacher's pension fund as an example. This fund pulls money together on behalf of retirees and then is managed by a fund manager to generate revenue. Let's say this fund needs to achieve an annual return of seven percent in order to meet its obligations to the retired teachers—things like sending monthly checks to the retirees to help cover living expenses in retirement.

This seven percent return target is also needed to ensure the pension fund doesn't run out of money and so that the pension fund can increase its benefits in line with cost of living increases. The investment manager of this pension fund can spread out the fund's money over several types of assets.

These various assets each possess varying degrees of risk and expected returns. There is cash, bonds, stocks, and then what is referred to as alternative assets, with the main categories being real estate, private equity, and venture capital.

On one end of the spectrum, you have cash. Cash has the least amount of risk but also has the lowest expected return. On the other end of the spectrum, you have alternative investments. These are considered to be the most risky but at the same time carry with them the highest expected returns.

The job of the investment manager is to achieve that seven percent return target while taking the least amount of risk possible. If the fund manager was deciding how much to invest in each category during the year 2021, when interest rates were zero percent, his options may have looked something like this: expect a return on cash zero percent, expect a return on bonds two percent, expect a return on stocks eight percent, expect a return on alternative assets twelve.

If the fund manager would have just split the pension fund's money among the four categories evenly—so 25 in each—the combined return would only be 5.5 percent, short of that seven percent target. Naturally, the fund manager wants to make sure to hit that seven percent return target for two main reasons. The first being that he doesn't want to get fired and lose his job, but the second being that he doesn't want to be the guy that caused the pension fund to fail to meet its obligations to the retirees.

Given the low interest rate environment, the fund manager is forced to do what is referred to as "going out on the risk curve." This means that in order to hit the required return, he is forced to take money out of the safer investments and move it to the riskier investments. In this example, that means taking down how much cash is in the portfolio from 25 down to just five percent. That money is then put into more risky assets—stocks and alternatives.

Now stocks make up forty percent of the portfolio and alternatives make up thirty percent. The good news is, now that we can see that the pension fund is meeting its return target of seven percent. However, now, seventy percent of the pension fund's assets are invested in stocks and alternatives, as opposed to just fifty percent previously. This makes the pension fund vulnerable if there were to be a protracted downturn in the stock market and economy.

Let's see how higher interest rates change things. Instead of cash producing a zero percent return, let's bump that up to four percent, and instead of bonds generating a two percent return, let's say that increases to seven percent. We'll keep the expected returns for stocks and alternatives the same.

As a quick side note, when Dalio says that cash is more attractive now than before, relative to other assets, this is what he means. The difference between what you can expect to earn on your cash compared to the stock market has shrunk as interest rates have increased.

If the pension manager splits the pension fund evenly across all four categories, the portfolio is now generating a return of 7.8 percent. This increase is due to the higher returns from cash and bonds. That 7.8 percent return is nicely above the fund's 7 percent target.

Instead of having to put more money in riskier investments to meet the return requirement, because of higher interest rates, the fund manager can actually do the opposite. He can take down the stocks and alternatives to just 15 percent of the portfolio each. He can bump up bonds to 40 and have cash at thirty percent of the portfolio.

Notice now that 70 percent of the portfolio is in the generally less risky categories of bonds and cash. Even with the much larger weighting of cash and bonds, the portfolio is still hitting its seven percent return requirement.

Well, I used a pension fund in this example. Everything we just talked about applies to your own personal investing portfolio. For the first time in nearly a generation, having cash and bonds in your portfolio isn't causing you to lose money after factoring in inflation.

As an investor, you always need to be thinking about your returns and what is referred to as real terms. Back in 2021, the interest rate on my high-yield savings account was a whopping 0.4 percent. I feel like calling it a high-yield savings account with that low of an interest rate should have been illegal.

Assuming even a normalized inflation rate of two percent, I was essentially losing money by keeping money in this account. Here's what I mean. I was earning a return of 0.4 percent. In order to calculate my real return, I need to factor in the impact of inflation. A shorthand way of doing this is to simply subtract out the inflation rate from whatever your return is.

If we assume a two percent inflation rate, that means my real return was negative 1.6 percent. Making matters even worse, the inflation rate wasn't two percent during this time period—it was five, six, even seven percent—making my real return even more negative. This is why Ray Dalio is proclaiming that cash is trash. By holding on to large amounts of cash, you essentially were getting penalized as inflation far exceeded the minimal return that you could generate.

However, the recent rise in interest rates has changed things. Now you can earn four to five percent by holding cash or cash-like assets, such as short-term U.S. treasury bonds. If you go back to a real return equation and bump up the return to five percent and keep inflation at two percent, we can see our real return is now three percent.

Assuming inflation will return to more normal levels, this is the first time in the investing lives of many of the people watching this video that the real return from holding cash is actually positive. This is a complete paradigm shift from the last 15 years. Personal finance influencers and YouTubers were saying that if you have more than just a few months' worth of living expenses sitting in cash in your account, you were an idiot.

Inflation was eating away at your purchasing power. That excess cash needed to be invested in the stock market and real estate as quickly as possible. That logic may have been sound at the time. However, the argument can be made now that it makes sense to hold cash and wait for a great investing opportunity.

Returns on cash are at the highest in 15 years, and stock prices and real estate values are still at or near all-time highs. Heck, even Warren Buffett, the greatest investor of all time, is sitting on over 100 billion dollars of cash currently.

As billionaire investor Charlie Munger says, "When the world changes, you must change." Well, higher interest rates are quite a big change for the investing world and the economy. Make sure you change accordingly.

So there we have it! I hope you enjoyed the video. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.