Charles Koch  1:43  

I had always been a big fan of science and the philosophy of science. I internalized Newton’s insight of “If I see further, it’s because I’m standing on the shoulders of giants.” 

I said, “What I’ve got to do is go find these giants and go find the principles of scientific and social progress. Then figure out how to apply them in my life to enable me to be the best me I can be.”

I then started studying everything I could that was relevant for all different subjects, fields, and from all different perspectives to find those. When I would find a principle, I would apply it in every aspect. I could find ways to apply it. That would be in a business with my family, my charitable activities, my community, and so on. 

If I could take a minute to just give you one example here, among the other things I learned early on is why did humanity go along for millennia, in which the common person gained almost nothing in the quality of life and standard of living up until the 18th century?

Then in various parts of the world, quality of life exploded. So we have what’s called the “hockey stick.” 

I discovered that it was when the common person began to be given equality under law and social dignity. That was brought about by a convergence of a number of changes, including the printing press. 

What that brought about is the common person, and I’m talking about merchants, traders, artisans, working people, but before that the aristocrats and the hierarchy, they were the dig-and-bread people, the working world. They were kind of lower, discouraged, and disrespected. 

This started to change in various countries at different rates. It’s because this then gave the common person the courage and incentive to better himself. In the process, he bettered the people around him. 

We started getting innovations, progress, and more open trade so people could exchange. That’s the other part I learned that in a voluntary exchange, people enter into voluntary exchanges because they both believe they will benefit. 

The way I internalized all this was, “Okay, the way to be successful in business is don’t focus first of all on how to maximize profit? How do I get more money? It’s how do I create value for others and what capabilities do I need to be? Which customers can I create the most value for?”

Stig Brodersen  5:04  

I really like what he was saying here. I think it’s very insightful. What Charles Koch is really talking about here is what he typically refers to as the good profit. It’s the profit that comes from treating customers with respect and placing values first. 

More importantly, it is to understand how he wants to engage in those win-win situations and those voluntary relationships because at the end of the day, one of the things he’s big on is that you can’t sustain profit, if you’re not creating value for society and if you’re not benefiting the people. That is where you start and then the profits will follow. That’s his basis for these systems he has built and for the companies that he has built. 

I think it’s really interesting how he talked about this field of philosophy of science. I remember, as a grad student myself, when I had an introduction to the philosophy of science, it was the worst course you can ever think of. Why would you need that when you’re doing a degree in finance or in business? What that’s getting at is the reliability of scientific theories and what qualifies as a science. 

If there’s something that we have seen here on the podcast, you can think of Charlie Munger and you can think of Ray Dalio, obviously also Charles Koch. They have mastered so many different skills.

I think that whenever you’re talking about how you succeed in business, which is really what this question was about, I think that it’s by understanding science and understanding different fields. 

When you put that together, it really comes down to how you benefit society and then the profit will follow. I really wanted to play this question as the very first one because that is Charles Koch’s framework of doing business that is what is benefiting society and other people.

Preston Pysh  6:51  

The way he starts off answering this question is way more profound than I think maybe some might see at face value when he says the quote, “They’re standing on the shoulders of giants.” 

It kind of gave him the starting point on his journey to understanding business and how to be a success in business. I would take that a step deeper once you do discover a person that you admire, maybe somebody that you want to be like in business, don’t just go out and read an article online about the person and stop there. You really have to go a lot deeper than that. You have to try to explore what books influenced that person, how can I learn everything I possibly can about this person in order to truly stand on the shoulders of giants. 

Then, just don’t do it once, but find 10 giants, and then replicate that same process over and over again. I think that if people actually take that to heart and try to do what he just said, they’ll find tremendous amounts of success at whatever they’re actually trying to go after and achieve. 

The other thing that I think is really important about Charles Koch, and it kind of reminded me after I heard him talk from reading his book, “The Science of Success,” is he does focus on what is profit. 

For example, when you start a business, why should you be allowed to have a profit on whatever product or service you’re selling? What it really comes down to is you are making other people’s lives better, typically by saving them time.

If you can deliver a product or a service that adds value to that other person, and you’re doing it in a way that’s better than anybody else out there, you deserve a profit. You can charge a premium on that. You can collect the 10% above and beyond what the cost is because you’re making value for that other person.  

I think a lot of people in business might not necessarily keep that at the forefront of their mind as they’re conducting business. But the thing is, some people in business feel like they’re entitled to have that profit when in fact, they absolutely are not entitled to have the profit. 

When you think through this framework, the thing that you ultimately come to the conclusion of is that because you’re not entitled to have the profit, you’re always worried that you’re going to lose the customer and that maybe you’re not creating value. 

Then you do things to continue to protect yourself from losing that profit because you’re not entitled to it. That’s something that I think Charles Koch has in spades whenever he thinks about the way he conducts business.

He might be thinking, “Hey, if I’m not adding value, well, then I’m not entitled to this process and things are going to be commoditized. I got to think of a way to improve or to add that value somehow in some way.” 

I just think that that’s really profound to think that way and I think that at the essence of business, you have to start with that framework. If you do start with that framework, it’s very profound for your long term success. 

One of the things that people might not realize is that the Koch brothers’ father was a huge entrepreneur and success in his own right. If I got this right, he was a chemist. 

 of the questions that Charles was asked, “What did you learn from your father that shaped you to become the success that you are today?” This was how he responded.

Charles Koch  10:01  

My father considered work ethic attitude toward work as critically important for developing yourself, in fact being healthy and happy through your life. He believed that unless you start working at an early age, you never really develop the skills, habits and values necessary to make you productive. 

He told me at an early age that he didn’t want country club bums as he facetiously put it. So there was going to be no country club in my life as a boy. 

He started me out digging dandelions when I was probably six years old in most of my spare time. I thought I’d soon get over that but it escalated from there. We had horses and cows out there, I cleaned out the horse stalls. I helped bale hay. 

Later when I was in high school, I milked cows before I went to school and afterwards. Then in the summer, I would work at various places. I worked on ranches. At one ranch, I rode lined, that is road fences to look for breaches and fix those then bring in bowls that had huff rod. That was a very interesting experience. I bumped in an old log cabin way out in the Centennial Valley, which was miles from the nearest place. 

I had two younger brothers and years later, my father didn’t require them to do the same level of work that I did. So I asked him, I said, “Why aren’t you as tough on my brothers as you are on me?” He said, “Son, you plumb wore me out.”

It was a very strong quality of my father. He was an absolute bear on integrity, both for himself and others. He was widely respected for that. Whatever he committed to he would do absolutely. No matter what. 

As a part of integrity, he believed that if you said you were to come meet somebody at two, you were there two or before. You weren’t one minute late or five minutes late. So, when I was in graduate school in Boston, he had asked me to meet with him there, to sit in on the meeting. He was having a business meeting. I had an awful time getting a place to park. I arrived five minutes late. He was standing on the steps of the building waiting for me and smoke was coming out of his ears. I was never late again with him, and I’m rarely ever late on anything. 

He taught me some great lessons. The values that were of most importance to him, I would say were integrity, humility, work ethic, experimentation, entrepreneurship, thirst for knowledge. I would say those are all key elements in market-based management and all parts of our guiding principles.

I think the key, and we talked a lot about mental models, and everyone has mental models to interpret reality and be able to function in the world. The key on whether they’re useful or destructive is whether they fit reality. I was blessed then to have a father who had strong mental models such as those I just described. They fit reality and they are very helpful to me and to our businesses being successful over the years.

Preston Pysh  13:28  

Awesome points here, but I just want to compound on some of the ideas here quickly. The first thing that he’s talking about was work ethic. There’s a really famous book out there called “Grit,” this idea of just working really hard and being able to achieve things. 

I would ask a question, and I don’t know if there’s an answer to this, but how do you teach somebody to have a hardcore work ethic? 

I personally think the answer to that is that you have to just get out there and do it. It has to be something that is bred to your own personal culture. You have to get out there and you just have to get after it. 

I come from a military background where you have to get up early, you must work extremely hard, you have to work long hours nonstop. It doesn’t matter what day of the week it is. 

The other thing I want to talk about, because I think this is so vital, is his integrity. He’s talking about how this was the big lesson his father taught him, but I want to look at it from a different vantage point. I want to talk about what integrity enables in your life? 

I think that it comes down to variants and volatility. If you’re the type of person that goes around, you never lie, and you’re always telling the truth, because this is reciprocal stuff. If you go and you lie to somebody, the chances are that person is going to come back and maybe be dishonest, or maybe not even lie back to you, but just treat you differently after they figure that out. Let’s face it, folks, the truth always comes out. It’s just a matter of when it comes out. 

They’re going to treat you differently. What you actually create, when you don’t have integrity, you create this environment of volatility and variants in your life that is very unpredictable. Then it just kind of compounds on itself so that you have no control over what’s happening to you anymore. Then you get into this blame game type mindset. 

When I was at the Military Academy early on, at West Point, one of the things that surprised me, I just didn’t quite understand this, every time a graduate would come back, and they were 60 or 70 years old, they would talk to the Corps of Cadets at the Military Academy. The one thing that they would always talk about was integrity. I just kind of found that a little surprising and that it was always brought up. 

Then having served in the military and I got older and had these different engagements, I really started to understand why it was so important. A lot of it comes down to just creating this environment around yourself that’s predictable and that everyone around you treats you well. You don’t have this variance and volatility in your life anymore. 

So, just amazing points. I would love to touch more on the thirst for knowledge and humility but I’m going long and I want to hear Stig’s comments. Stig, I’m curious what you have to say. 

Stig Brodersen  16:16  

I would also like to add a personal story into the mix. There’s a good chance that quite a few of the listeners won’t like me after hearing this story, which is also why I waited more than 200 episodes into TIP before telling it.

When I was a college professor, the way we measured ourselves, there was not only the academic credentials, but also how the companies evaluated the graduates that we sent out, which to me was a fabulous way to do it. I mean, they are after all the end product.

Now, I worked there for years, and I never heard any company come back and say that they didn’t have the academic skill set that was needed to take on that job. What I often heard is that they did not have the right work ethic, which really comes back to what Preston said. How do you teach people to have the right work ethic? It probably doesn’t come in college. It is probably something you should have learned from your parents. 

By the way, that’s also another way we grade in our institutions. Those are tests and exams, it’s not work ethic. It was just so embarrassing to get feedback from employers that were saying, “He’s not there on time, or sometimes he even checks his Facebook when facing clients.” 

I mean, you could just imagine how you would cringe when you hear something like that. One of the things I did was when the class started at 8:20, I locked the door.  I literally locked the door and students couldn’t get in, which was very shocking to quite a few students. 

Then whenever we had a break, other professors would give you 5 minutes or 10 minutes break. If you give a group of students a 5-minute break, you won’t see the students any time soon. I can swear to that, but I gave them 7 minutes and 43 seconds, and then I locked the door. 

I had a big timer up there so everyone could see. Then there was a loud buzzing and I closed it down a second. I had students standing outside, if they’re one second late because that was one second late. I didn’t give them 7 minutes and 44 seconds. I gave them 7 minutes and 43 seconds. There’s a difference there. I know this might sound extreme. 

By the way, I did that in every class throughout the year. I really did this well, honestly, because it was a lot of fun. That was one of the main reasons, but also because it really taught the students… 

We had a lot of international students too. Lots of different backgrounds, social backgrounds, a lot of different cultures. It was really also to adapt them to the type of companies that they would typically go out to after they had a business degree.

These companies if you’re there at eight, it is not 8:01, at least not where I’m from. It’s eight o’clock. So it was really to instill that work ethic. 

My two key takeaway was really, if I could say something, be there on time, do as you say and say what you do. It’s just so fundamental to everything in business.

Preston Pysh  18:59  

You would have done really well at West Point, because in all of our classes and in all of our classrooms, we had GPS timed clocks. There wasn’t like a bell or anything like that. If you literally showed up one second late, your teacher would give you what was called 10 hours. What that encompassed was you had to go out in the area, you had to get in your full military uniform, and you had to carry a rifle back and forth on a line for 10 hours during the weekend. 

So on Saturday and Sunday, you’d have to march your 10 hours back and forth in a line for being one second late to a class. This is every single class, so not only were you penalized for whatever in the class, but then you had to go walk your 10 hours after you were late. Then you’re never late.

Stig Brodersen  19:47  

Another thing and I know that we might be joking about this, and some people might be like, “Oh my god, Preston and Stig, horrible people.” But I think it’s also important to know what it is you’re signaling. If you are late, if you don’t do as you say, it’s a sign of disrespect, not just to yourself, which is extremely important, but to your fellow students and fellow cadets.

Preston Pysh  20:12  

What you’re really saying is I can’t even manage myself, let alone somebody else. That’s really what it gets down to. 

Anyone who’s in business and who manages a bunch of people will quickly pick up on the theme of work ethic. If you can’t take care of yourself just to show up somewhere on time, how in the world are you going to manage 10 people to show up on time? You just won’t. 

We might come from extreme backgrounds. I’m sure other people see this differently. I’m sure some people were very successful and show up late but it’s just one little facet of work ethic that I think sets an example. 

Let’s go to the next question. On this question, Charles was asked, “How do you choose among the various business opportunities you have?” This was how he responded

Charles Koch  20:51  

To believe that you can create superior value for your customers and unless you can create more value, then there are alternatives for them, you’re not going to succeed in that business. 

Then you need to believe that it’s sustainable, that it’s not just you getting in and they’ll immediately copy you or somebody will come up with a better way of doing it, then you’ll be out of business. So those are some of the things we look at. 

Then another piece of it is to when we’re entering a new business is to do it at an experimental level that is a small enough level that if it fails, it’s not going to cripple us or destroy us. 

Another thing even before we start the experiment is to have an internal challenge process where we don’t say, “Okay, we got this vision and we don’t want to hear any naysayers.” No, we want to hear naysayers, not from people to prove they’re smart or just stop us. We want people to point out the flaws in our strategy and in our theory that we can create superior value because you’re better off to learn the flaws in your thinking before you plunge into it than afterward. I’ve never understood people who want to protect their ideas and not have them criticized. 

Any decision I make, when I think we ought to make an acquisition or implement a strategy, I look for what are the key drivers in success or failure in this venture? Who is really good at each one and each aspect, whether that’s operations, marketing, distribution, whatever it is? I want challenges. I want people who are going to come in and say, “Oh, tell me what’s wrong with this? How can this go wrong? I want to understand all the pitfalls.” 

Every time we go through that we come up with a better answer than I had to start with.

Preston Pysh  22:51  

This idea of prototyping things or prototyping ideas, I think is such a smart way of doing business. Anybody who has run a successful business would realize how important this idea is. 

From an online perspective, there’s an idea of prototyping where you can literally launch a digital product without really actually having the product out there. You can run data through this and you can run traffic through it to see if the idea or product might be viable. 

When you look at a business that’s not like an online business like I just described, and let’s say you’re working for a large business and you want to prototype something, maybe it’s a launch in just a small town or it’s a launch in one city to see whether it works. But this idea of prototyping is really important.

Stig Brodersen  23:40  

At the end of the day, business is about getting the maximum out of scarce resources. That typically is referred to as time and money. No one has enough time and money. That’s really the nature and guiding principle of business because we could always be investing in something else and spending our time and money on another business project. So what do you do? 

One key thing is yes, have it criticized as much as you possibly can. I think anyone in business will quickly realize that the best investments you make are those you do not make in the first place. 

The next thing about the experiment that Charles Koch is talking about, and Preston gave a really good example of this in terms of the online world, now optimizing the relationship between effort and information. I’ve never met any business person who made a business plan years out, and then that was exactly what happened. That’s not how life works. Not life, not business. 

You need to test it first, get all that information and make a decision based on that. For example, should we continue, should we pivot? What should we do? Perhaps the best example of this optimizing the relationship between effort and information really turned out to be massively successful was Zappos.  

Zappos started with a guy who wanted to buy an online retail store for shoes. This was back in 1999, and you did not buy shoes in 1999 online. What he did was he went to the local store, took pictures of the shoes, put them up on the website to see if anyone wanted to buy them. If they did, he went down to the store, and he bought them at retail and then shipped it to the customer, probably at a loss because he just wanted to check the system. He wanted to know how he could get the most information with the least amount of effort.

He didn’t have to think about investing in infrastructure and inventory. No, that was not the point. He just wanted to see if it was a valid business model, and it was. As I’m sure some of you in the audience know that it was extremely successful. It was sold to Amazon for a billion dollars, but it was just how it all started. If you had to make all the upfront investment, the founder, Nick Sherman might not have done so in the first place.

Preston Pysh  25:48  

Moving on to the next question here, Mr. Koch was asked, “Your business is built around what you refer to as creative destruction. What is that and why is it important in business?” Here’s the response.

Charles Koch  26:01  

Data from a great Austrian economist who ended up teaching at Harvard called Joseph Schumpeter, the way he defined creative destruction is the process of industrial mutation incessantly revolutionising the economic structure from within. Incessantly destroying the old one and incessantly creating the new one. 

His point was when we’re competing, we think, “Okay, we’re competing, productivity, output and price and those things.” That’s true short term, but Schumpeter’s point is longer term. 

What you’re really competing in is you’re competing with the new commodity, the new technology, the new source of supply, the new type of organization. So you need to not only be improving your current cost structure and how you compete on price and service, but these modes revolutionary long term changes. You see over time whole industries are driven out. That’s what he means by creative destruction. 

We believe and this is part of this, what we call this virtuous cycle, is continual transformation. Since I’ve been with the company since 1961, we had five transformations and the one we’re going through now is to introduce the best technology into all our businesses. 

We are just getting remarkable improvement by combining different forms of technology, whether that’s electronics, connectors, sensors, and software, whether that’s predictive analytics, artificial intelligence, robotics. We are using all those forms of technology to transform all our businesses: manufacturing, customer deliveries, understanding what our customers value and so forth.

Stig Brodersen  28:04  

Creative destruction is just one of the most important factors to understand the competitive forces in business. I would also argue as a stock investor, as business people, we should always think of how can the marketplace make us obsolete? How can we continue to be in a learning curve that is ahead of the market and ahead of the frontier? 

One example that really comes to mind is the rivalry between Kroger and A&P in groceries. This was one of the famous examples that Jim Collins made in his book “From Good to Great.” It talks about how it was different than the mega stores you see today. It’s not like you can go to your Walmart and you could get new tires, you could pick up your drugs, and everything. It’s not like that. It was these small shops and you just have multiple of them. They service a very small area. 

Back then, 100% of A&P’s revenue, there were these stores. It was the same with Kroger. What was really interesting at this point in time was that even though 100% of the revenue came from that old business model, Kroger continuously talked about how this is going to change. How can they be outcompeted? 

So what they did was they started building those huge stores that had everything, which is also one of the reasons why they became so successful. A&P instead started to compete on the prices, but that was not what people wanted. That was not the way the development was going. It was a different lifestyle. You should be able to fix everything in one trip. It was not a question of saving a few bucks. It was convenience more than anything else. 

By doing that, by making that gradual transition, Kroger made their own business model obsolete. A&P did not and by the way, also went bankrupt. This is what Charles Koch is talking about. Always question your own business. Who is going to outcompete us?

Koch Industries is now through the six major transitions since this started. They keep on evolving, they keep up with the times. That is really what this creative destruction is all about. That’s also whenever you see these stats about which kind of companies were the biggest in Dow Jones 20 years ago, then 10 years ago, and then today. There are companies that are being replaced all the time if they can’t keep up.

Preston Pysh  30:25  

I think this personally just goes back to the original discussion we were having about what is profit, and just understanding that whenever you’re creating real value for some person out there that’s buying the product or service, if that value is not sustained, that’s your creative destruction right there. 

You have to always be aware that somebody is trying to commoditize what you’re doing or trying to replace what it is that you have created, or what it is that you’re doing. People that aren’t thinking of it from that dynamic at all times, they’re just not going to have long term sustainment of their business.

Stig Brodersen  30:57  

I think as stock investors, we should think about that too. Have that framework in terms of determining what is the mode of that business? How is it benefiting society? Can it be displaced with something else? 

As much as I would like to say that Warren Buffett does not invest in tech, even though it seems to have changed, I think that is one of the things he’s been famous for. He does not want to invest in companies that need to reinvent themselves. It’s such a hard business to keep reinventing yourself, especially if you’re new to the tech field.

Preston Pysh  31:25  

There’s a really good book called “The Innovator’s Dilemma” and this is by Clayton Christensen. He’s out of Harvard. The book talks about how sometimes the best way for a business to create new products isn’t necessarily inside of its own foundation, but to allow a few people to step outside of the business, start their own business, and try to launch a competing product. 

One of the reasons why is because it forces people to get out of the mindset of “Well, this is how we’ve always done it. This is what works. This is what we know works.” It’s just trying to look at something from a completely different vantage point. 

I highly recommend that book. We also have a free executive summary of that book. Stig and I have covered that in a previous episode, which we’ll have in the show notes if people want to check that out as well. 

All right, so that’s all we have for covering some of the Charles Koch’s Q&A. Now what we’re going to do is we’re going to transition into a question from the audience. This question actually comes from two people. It comes from Jonathan and Rochelle. Here’s their question.

Jonathan  32:24  

Hi, Preston and Stig. This is Jonathan and Rochelle, soon to be married. We’ve been on this new journey together of value investing for about two years now. One of our fundamental values is what we like to call food and time. There’s no better place to enhance these values than Omaha for steaks and the Berkshire Annual Meeting, which we will be attending for the first time in 2019. 

Rochelle  32:44  

In regards to time, we’ve been sticking within our circle of competence and learning from investment gurus like Warren Buffett, Ray Dalio, and Jesse Felder. Just to name a few during this volatile market With methods like the All Weather Portfolio, it holds about 40% in long term bonds and 7.5% in gold. 

In a recent episode, you answered an audience question similar to this, but what are both your thoughts on setting up our security bucket versus our growth risk bucket going forward that caters to all the All Weather Portfolio, which includes bonds and gold.

Jonathan  33:15  

We currently hold about 80% in cash. So in a way, we are excited for future market opportunities of growth.

Rochelle 33:22  

Thanks again for all that you guys have done for the value investor community. See you in May. 

Preston Pysh  33:26  

Oh man, I hate to say this but Stig and I are not going to the Berkshire Shareholders meeting this year. I feel terrible saying that, but we both just needed a break this year. I have a bunch of stuff that’s happening in May. I personally can’t make it and Stig?

Stig Brodersen  33:43  

Yeah, my excuses are more or less the same. I can’t get my calendar to match up and it’s a bit trickier. I had to fly in for Denmark for a weekend, which I do every two years. Unfortunately, I can’t make it happen in 2019.

Preston Pysh  33:57  

But here’s the thing, there are a lot of people that will go to this meeting. I know Patrick O’Shaughnessy goes out there and Shane Parrish goes out there. There are tons of people you guys can hang out with and connect with. Hit us up on Twitter, if you guys need any introductions to find out what some of the other people that are going out to Berkshire will be doing.

Stig Brodersen  34:15  

Before we actually respond to your question, I just wanted to put out there that we have a guide on our website in terms of how to attend the meeting. We have that in the show notes. There are also going to be links to the forum where you can team up with other people from the community, if you want to team up with them and have someone to go to the meeting with. 

Before we respond to the question, I just want to say for the record that I do plan to go in 2020. I do plan on persuading Preston to go as well. It is a lot of fun.

Preston Pysh  34:41  

Oh, it is a good time. So let’s try to answer this question. I don’t know that I can actually provide a great response to this question because so much of it is really kind of centered around Ray Dalio and his personal approach to investing which we know is balanced across all asset classes, whether it’s commodities, bonds, current currencies or equities. He has a certain distribution in this. A lot of his approach is outlined in a book by Tony Robbins called, “Money: Master the Game.” 

If you’re trying to understand how Ray invests, I would tell you to pick up that book. I would also tell you to pick up the “Hedge Fund Market Wizards” book by Jack Schawger, awesome profile of Ray Dalio in that book as well to kind of tap into his mindset. 

I personally have a gold position right now. This is January 2019, the beginning of January 2019. I’ve had that gold position on for a few months now. I think commodities are going to do well in 2019, but I think the thing that’s going to be the trigger for that is when the Fed kind of reverses their tightening that they’re doing right now. 

So, that is when they stop their quantitative tightening, when they stop doing their federal funds rate rises, I think that you’re going to see a very strong movement in most commodities. Oil specifically, I think is going to have a really strong upside here in 2019 by the end of 2019. So I don’t know, I’m a fan of that space. 

As far as bonds go, I think bonds are going to have a pretty rough time in 2019. Here’s my reason why. If you buy into the idea that commodities are going to do well, once the Fed kind of changes course, that means that inflation is going to be much higher than it is right now at the start of 2019. 

If that’s a true statement, that’s going to absolutely get priced into the bond market. You don’t want to be sitting on bonds when inflation… especially if this kind of goes the way I’m thinking… I think that it’s going to actually be somewhat aggressive to the upside in the commodities, which is going to be a pretty drastic move for bonds. Not in a good way for bonds. 

I’m not a huge fan of you know where that’s going, but I could be wrong. Ray is in a substantial position. 

Now one of the things I will say about bonds, especially short duration bonds, you’re not going to see too much of a price change in short duration bonds. With long duration bonds, you might see some pretty large and substantial price moves. However, relative to equities, the price volatility is not anything like an equity. I think that that’s important for people to understand and I think it’s also important for people to understand the commodity volatility and price is really high. 

If you’re talking about volatility differences, with currencies, you don’t have much volatility at all. Then you go to bonds, they have a little bit more. Equities have a lot more than that, and commodities are hands down the most volatile out of all of them. So you have to understand that. 

If you are planning to invest in any one of those four asset classes, you understand that if you are wrong, the more volatility like in commodities, if you’re wrong in commodities, it’s going to be a very painful experience.That’s important for people to understand. 

The way that Ray weights his exposure to a lot of those has to do with the volatility of each one of those asset classes and then trying to balance it. Then he balances it based on leveraging some of those positions so that they cancel each other out. So I think that that’s important for people to understand that approach. I don’t know if I really answered your question very well, but I told you some of my thoughts for what I’m expecting here in 2019.

Stig Brodersen  38:16  

If we look at the asset allocation in the All Weather Portfolio, Ray Dalio has 4% in long term bonds, actually 20 years and longer. So he has a lot of interest rate risk: 30% in stocks, 15% in intermediate long term bonds, 7.5% in gold and 7.5% commodities. 

The reason why he refers to this as the All Weather Portfolio is that he generally says that there are four different seasons that the economy can go through: higher than expected inflation, lower than expected inflation, higher than expected economic growth, and lower than expected economic growth. 

By having this asset allocation, the idea is to have a portfolio that can go through all of these seasons, and there should be a diversified portfolio that can consistently earn you money while keeping you financially secure during the bear market. 

For instance, if there’s a higher than expected inflation, it could easily hurt your bonds, but gold typically performs well. It’s a very humble approach to investing.

In the book that Preston mentioned before, Tony Robbins’ “Money: Master the Game,” he’s doing some back testing on this asset allocation. The All Weather Portfolio produced just under 10% annually between 1984 and 2013, which is slightly less than what you would have if you just invested in the market.

What might appeal if you want to invest in the All Weather Portfolio is that you would have made money in more than 86% of the time. The average loss was just under 2%, which one of the lowest is being as low as .03%. So you do not have any ton of volatility. I think it’s completely fine if you look at an asset manager and you say, “I would like to compare your returns to the S&P 500.” That benchmark.

However, for a lot of people, companies and other asset managers, they’re not comparing themselves to the S&P 500. It might be an endowment. It might be a retail investor who’s looking to live off his portfolio and it might be a retail investor who is looking to retire and is not looking to maximize their return. 

Sure, maximizing returns would be a great upside, but the downside of losing a principal is just so much worse. For them, something like the All Weather Portfolio, I think it’s a very interesting strategy even though you do not have as high of a return.

Preston Pysh  40:43  

I got two more points based off of what Stig said there. So you heard Stig say that if you would have executed this All Weather Portfolio, you would have done slightly worse than the way that the market would perform. Though your worst performing year would have been down 2%. 

What you gained then by implementing Ray’s approach that was outlined in this Tony Robbins book is that you don’t have the volatility that you have, if you would have just been in the S&P 500. You minimize that volatility. 

What it really comes down to is a personal preference and what you can stomach if you’re the type of person that cannot stomach a huge loss and then implementing an approach like the one that’s outlined in that book is probably a great way to look at things and to go about it. This is because you’re just not going to see those big wild swings. 

That’s the big thing with Ray that when you study what he does is he is trying to understand what volatility looks like. Then what he does is he designs a portfolio around something that fits that appetite or that personal preference based on the return he would expect to get and the volatility that’s associated with it. That’s the brilliance of Ray Dalio. 

Now, something else that I think’s important is when you get into this risk parity strategy because that’s where with Ray invented, he also has a thing called “plunge protection” that’s built into his strategy that is not talked about at all in Tony Robbins book, or pretty much anywhere else that you can find. I would argue this is very proprietary for what Ray does is when does he turn off his risk parity? Because I mean, really the trigger here is he’s offsetting. 

Let me just give you an example of equities to bonds. When equities go up, typically, bonds are not performing well. When bonds are performing really well, equities are not so that’s your risk parity. But over time, if you own both asset classes, and you leverage them up so that they have equal weighting, what happens is that in aggregate of owning both of those asset classes, you make money over time.

When that’s not true is when you get into a systematic credit event, where both asset classes bonds and equities both go down. So this is where we get into his plunge protection on his All Weather Portfolio. This is also true for currencies and commodities that he would have this plunge protection built in. 

Some of the things that he’s looking at with this plunge protection is he’s looking at if prices are high relative to traditional majors or prices are discounting future rapid price appreciation. Also, purchases being financed by high leverage or buyers and companies making forward purchases. Is there a broad bullish sentiment? He’s looking at those types of factors, if there’s a tightening risk that’s popping the current bubble. 

Those kinds of things are what he’s using to gauge whether his plunge protection basically liquidates a lot of those positions. How did he liquidate his positions? I don’t know and I think that that’s part of the secret sauce of Ray Dalio that’s never discussed and that’s vital to his success and ability to navigate these markets like in 2009. I think he was up like 8% or 9% in the green when the rest of the market was down 50% to 60%. That’s vital. 

If you think you’re going to just turn on an All Weather Portfolio and think that you’re going to have similar returns during down markets… I think people really need to be well aware of the complexity that they’re not getting by reading a book by Tony Robbins or anything else that you’re reading on Ray Dalio. 

All right. So Jonathan and Rochelle, that was probably way longer than you wanted to hear for our response, but a really, really complex question there. I don’t even know that we did it any kind of justice, because trying to cover Ray Dalio is not an easy task. 

He has a lot of writings out there. I’d tell you to try to read everything you can get your hands on, specifically “Big Debt Crisis” by Ray Dalio is a phenomenal read. Also, there are white papers that you can find out there online and various PDFs that can help you understand his risk parity strategy. 

As a token of our appreciation for leaving your question, we’re going to give you access to one of our free courses on the TIP Academy page on our website. The course that we’re going to give you is our intrinsic value course. 

Our intrinsic value course teaches people how to determine the value of an individual stock. It also teaches you how to think about the market cycle and when you’re buying your stock. It also teaches you some stuff about options trading. So, we’re really excited to give you this course. 

If anybody else out there wants to check out the course, you can go to TIPintrinsicvalue.com or you can just go to our website and click on the Academy link at the top of the page and courses right there. 

If anyone else wants to leave a question on the show, go to asktheinvestors.com and if your question gets played on the show, you’ll get a free course. 

Stig Brodersen  45:40

Alright guys, that was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro 46:16  

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