Speaker 1: Have you ever wondered, is there a perfect amount of stocks that I need to own that will maximize returns yet reduce risk? Is there a perfect strategy, a blueprint out there that I can use? And this is a question that I’m sure has plagued Dalia’s mind for a long while. How do I balance my investing strategy flawlessly and right? Allio, I don’t know how long he has been working on the strategy for probably years. Just experimenting with different variables and amounts like a scientist would, except instead of chemicals is focused on investments. And over time he developed a strategy called the Holy Grail of investing.
The Holy Grail strategy answers the question How do we structure our portfolio for maximum returns at as low risk as possible? Luckily enough, DeLeo hasn’t just kept the strategy to himself. He shared it with the world. And I’m going to teach you the strategy and this video. It’s a very important one. OK, I need to bring your attention to this graph now. It may look a little bit confusing. A couple too many lines for you, perhaps, but I’m going to explain this very simply. So on the left side of the graph, we have portfolio standard deviation. This is just a way of measuring risk. OK, on the bottom of the graph, we have the number of assets in the portfolio. These can be stocks. This can be gold, real estate, any type of assets. So we’ve got risk. We’ve got the number of assets in. The third ingredient to this graph is correlation. So that’s the correlation between each asset. Now, for those who don’t know what correlation means, it just means how connected is each asset or how strongly linked are they together, for example, Coca-Cola and Pepsi stock, they will have a strong correlation because their consumers are similar, their business model is similar and they are strongly connected together. Whereas let’s say Costco and American retailer and the Royal Bank of Canada, they have a weak correlation because they are in completely different countries and they have completely different business models. So let’s get back to the graph. OK, now we’re getting into the meat and potatoes, the important part of it. So what this graph, we assume that we’ve got an asset that has a 10 percent risk and a 10 percent standard deviation. And to make it simple, we also assume that the asset has a 10 percent return and then you add on a different asset with the same return up until 10, 20, 30 times, however many assets you want to add. The question becomes, the more assets you add on, how does it affect the risk of the overall portfolio? And the interesting thing that you’ll notice is the more of these assets that you have, the lower your risk becomes. You see, as you go along the x axis, the more stocks and assets that you own, the lower the risk becomes. And this is why Dalio says diversification is not for idiots, it’s actually for the wise. And Dalio said knowing how to diversify well is more important than almost anything. But notice, he said, diversifying well, because you don’t need to own hundreds of different stocks to be well diversified. You see, if you look at this graph that we’ve been analyzing, there’s a point where increased diversification doesn’t do that much.
You see, anyway, after 15 to 20 different stocks, there’s not much of a decrease in risk. So that tells us when it comes to our portfolio, 15 to 20 stocks is all we need to be well diversified with as minimal risk as possible. Now, that’s a very important thing to know when it comes to your overall portfolio, 15 to 20 stocks. When you look at the science behind it is all we need. However, there’s more to it than that. What you’ll notice about this graph is there’s five different lines. Now, each of these lines represents a certain level of correlation between the assets. The red line at the top has a 60 percent correlation between assets and the green line at the bottom has a zero percent correlation. So I hate to point out the obvious, but the lower the correlation there is between each assets, the lower the risk is. As you can see, the red line at the top has a return to risk ratio of around zero point three one, giving it a 38 percent probability of losing money in a given year.
However, the green line with zero percent correlation to any stocks that only has around a twelve percent probability of losing money in a given year. So with the lowest correlation line, you keep the same return as the top line, but you lower the risk by four times the amounts. That is why it’s so important if you’re looking to build a well diversified portfolio to buy stocks, they aren’t strongly related. You know, look at buying stocks in different industries like consumer staples, travel tech. Finance, these industries are not linked closely together, and therefore your risk will be dramatically lowered, as Dalio says, the magic is you only need to do this simple thing.
The simple thing is to find 15 to 20 good uncorrelated return streams. If you can do this, you can improve your return to risk ratio by a factor of five. And the thing about risk is people often don’t comprehend it when it comes to their investing style or they care about how much gains they can make. It’s only the experienced investor who’s been through his fair share of rises and declines. Who knows the importance of risk. Like Warren Buffett, his first rule to investing is don’t lose money. His second rule is don’t forget rule number one. Well, he’s trying to get at is manage your risk. Well, pay attention to your downside. You know, I’ll give you a little example. Let’s say you own a stock. We’ll call the stock orange. Orange sells for one hundred dollars a share if orange goes down by 50 percent and now sells for fifty dollars a share. But if it goes up by 50 percent the day after, it’s only worth 75 dollars. So even though it went down and up by the same percentage, you have now lost a quarter of your investments. If it drops by 50 percent, it needs to go up by 100 percent in order to fully recover. And this is a perfect example why managing risk is so important, arguably even more important than your potential reward. And that’s the reason Dalia’s Holy Grail strategy is so important to all investors because it greatly reduces your risk. So now the obvious question becomes, how do we practically implement the strategy with our own portfolios? This is what I’m going to show you with the last section of the video. So remember, the Holy Grail is 15 to 20 uncorrelated revenue streams. And fortunately, Dalio has given us some good information on how we can implement it. So essentially, we can boil it down to four different types of environments in which we want our portfolio to do whalin. OK, increasing inflation environments with increasing growth, decreasing inflation environments with increasing growth, increasing inflation environments with decreasing growth and decrease in inflation environments with decreasing growth for types of environments. So the section with increasing growth when growth is high, you want to be in equities, you don’t have to be a genius to work that out. And I personally believe that the equity side to one’s portfolio is the most important side because throughout history it has offered the highest returns. Now, that’s how Buffett became so rich. Not through bonds, not through cash, not gold. No, it was through equities.
So equities, you really want to be exposed to the USA and other developed markets. These tend to do well during low or decreasing inflation environments. And you’ve got to make sure you’re on a range of different sectors that have low correlation when it comes to equities. For example, travel first, consumer stocks, as we’ve seen recently during the lockdown, travel stocks got absolutely beaten down in terms of price because no one’s traveling anywhere. However, consumer defensive stocks like Wal-Mart or Target, they did relatively well. Both of these have increased in price substantially. So travel stocks went down, consumer stocks went up. Why? Because they have relatively low correlation when it comes to equities. Make sure all your stocks are not just in one sector, but are in a bunch of different sectors. Another thing with equities is to diversify across countries as well. Emerging markets. They behave differently to develop markets and they tend to do well during periods with high inflation. So a well diversified portfolio will have both equities in developed and emerging markets. But at least according to Dalio, in order to be well diversified, you need more than just equities. Of course, gold is a big component of Dalia’s portfolio and is investing style. As you can see, it does well in the three different types of economic environments. But just in general, it’s a good way of hedging your portfolio. And by this I mean frequently when you’ve got a bunch of asset classes doing poorly and people are panicking, gold does fine and that’s exactly what a hedge is meant to do. So when it comes to the Holy Grail strategy, gold is great to use as one of your uncorrelated assets.
In this graph, Dalio gives more examples. So commodities emerging bond spreads, they work well in increasing growth and increasing inflation environments, inflation protected bonds for decreasing growth and long duration treasuries. Bond spreads, intermediate duration, treasuries and cash are more assets that Dalio gives examples of as uncorrelated revenue streams that you can use. You know, at this point, I’d recommend pausing the video insane. Which of these revenue streams is missing in your own portfolio that you may want to add in? Because if you do, it’s going to help reduce your risk, which is so important. As Dallier says, a lot of people think that the most important thing that you can do is find the best investments. That’s important, OK? But there is no great one big investments that can compete with something like this, the Holy Grail strategy, the Holy Grail. It’s the sweet spot between diversification and correlation.
You don’t need to own hundreds of different stocks to be well diversified. According to statistics and the data, 15 to 20 uncorrelated revenue streams is all you need. As Dalio says, it’s the surest way of having a lot of upside without being exposed to unacceptable downside.