Mr. Dalio, it´s good to think in risk, not assets

Today I must say Mr. Dalio hit me hard on the head. "Don´t think in terms of asset allocation, think in terms of risk allocation", he says. What is risk? How do you measure it? As you know from the articles in this blog, we expect to generate a certain return from an investment or will not proceed - hence our focus on valution. Our buy price is influenced by the cost of money (the risk free asset), and inflation expectations - as well as the return of other securities from that company, and the return of other companies securities. Hence our valuation is affected by our interpretation of the risks within the company, within the sector, and macro issues. If we do not see opportunities to buy securities of companies we will leave assets in cash, rather then guess what will happen everyday. We will wait for our fat pitch, the investment that we feel most comfortable with, hence we are less likely to loss money, and more likely to be successful in the investments we make. This is because we are not a large team, and because we have not built a large wealth of knowledge in macro economics, and how it affects the markets, and how macro events evolve. However, our return on investment focus, our investment process having a feedback loop from macro influences, means we do not allocate capital with a starting point based on allocation to equities or in bonds: we do not start from an asset allocation model, as Dalio warns against. We are prepared to take on a certain amount of risk for a certain return - if we do not find that opportunity, we do not deploy capital. Where Dalio differs is he incorporates in his investing that he will not know with precision what will happen. As a result he places off setting investments in case growth is not what he expects, or inflation is larger than he expects. We do this by security selection in portfolios, by having different companies in different businesses and sectors, with different catalysts and in different investment categories. However, most securities are equities, and hence will have a large beta component to their return. As a result, our instrument to fight against never really knowing everything - the margin of safety - will be of little use in the short term when markets fall - whilst Dalio´s offsetting trades can help him generate less volatility from trying to hedge where he may be wrong. We can say we dont want to spend the same amount of time on the areas we dont understand as much as the areas we do. But here we dont need to find different companies to short, as opposed to go long. Perhaps we need to spend time to find securities that are likley to bloom if certain things go against us in an investment case (this should be resolved through research of the company, unless very unclear but cheap to go short one item and long the other, then worth the risk), or maybe can offset beta risk. But the cost of shorting may eat away any alpha we may generate - hence we introduce a timing issue. When would be want to be short. When we see real problems and real extreme valuations. I have always tried to walk away from the timing problem by focusing on being long with no leverage. Each allocates capital to their skills. Business managers that dont short their sector in a recession are not poor managers - it is just they focus on the long term, rather than generating stable results on a monthly or quarterly basis. It is this preference that matters. Which depends on the skill of the manager, and the demands and expectations of the client. It is important this is well understood at the start of the relationship, or it will create problems just when their are enough problems already!