Bridgewater Hedge Fund: A Fall Leads to New Ideas

This article is an excerpt from the Shortform summary of "Principles: Life and Work" by Ray Dalio. Shortform has the world's best summaries of books you should be reading.

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What is the Bridgewater Hedge Fund? Who founded the Bridgewater Hedge Fund, and why was the company successful?

Bridgewater Hedge Fund was founded by Ray Dalio. After building and rebuilding his successful company, Dalio was alarmed by feedback about how people in the company were doing. This caused him to develop his Principles for life and work.

Read more about Bridgewater Hedge Fund and how Ray Dalio developed his Principles based on his work there.

Bridgewater Hedge Fund: The Downfall: 1979-1982

The late 1970s were one of the most volatile periods in markets in history. The fluctuations were caused by big shocks like breaking the link between the dollar to gold in 1971, the oil crisis after the Iranian Revolution, and the Fed’s monetary policy to try to control inflation.

During all of this, Dalio confidently predicted that the next depression was soon to come. He saw that debt levels were at record highs and rising faster than borrowers could repay them, particularly to emerging countries. The Fed was in a difficult position. It could print more money to avoid a cash crunch, but this would stimulate more inflation. On the other hand, if the Fed were to control inflation by becoming tight, this would trigger a massive decline in markets.

Dalio had seen elements of this before. He’d studied the past two centuries of economic history for debt and depressions. He was confident that a depression was coming, and he told his clients at Bridgewater this. To profit from his prediction, he held gold (which performs well in inflation) and bonds (which perform well in depressions).

At first, it looked like Dalio was completely right. In August 1982, Mexico defaulted on its debt, and it seemed clear that other emerging countries would follow. The Fed’s policies hadn’t been enough. Dalio’s bond bets were beginning to pay off. 

Dalio looked clairvoyant for his predictions. He testified at Congressional hearings on the crisis, and he went on finance shows, claiming “I can say that with absolute certainty, because I know how markets work.” The Fed tried to ease the situation by making money more available, but Dalio predicted credit problems would only get worse, seeing analogies to the Great Depression in 1929.

He was completely wrong. The market rebounded in response to the Fed’s actions. Inflation fell, and growth accelerated. Over the next two decades, the economy enjoyed the greatest growth period in history.

Dalio lost nearly everything. He had to let go of his entire staff, leaving only himself. He had to sell their second car and borrow money from his father. After eight years building Bridgewater, he had to start from zero once again.

Lessons from the Crash

What did Dalio learn from this incredibly painful experience?

First, despite losing nearly everything, he knew that he wanted to continue working for himself. He didn’t want to get a job. And if he was going to succeed in going after what he wanted, he needed to reflect on the failure and change for the better.

Reviewing his actions, he found a few critical mistakes.

  • First, he had been far too overconfident and emotional in his prediction. He vowed never to feel “absolutely certain” about anything again. Instead, he would need to constantly stress-test his ideas, seeking out people who disagreed with him and understanding their reasoning. This would increase his chances of being right.
  • Second, he saw that his study of history was incomplete. Had he studied other aspects of economic history, he would have seen that central banks could balance inflation and deflation against each other as they did in this period. He vowed to study history completely and assemble a set of principles that were timeless and universal.
  • Third, he had incorrectly perceived an all-or-nothing choice in his investing—he could either pursue high returns at high risk, or he could lower risk for lower returns. He saw that a low-risk, high-return path was possible. In general, the lesson was to keep finding the best possible path instead of settling for the obvious choices available.

In retrospect, this failure was one of the best things that happened to Dalio, because it revolutionized his approach to personal improvement and decision-making, and it led to a golden era for Bridgewater.

Revitalization to Today

Starting once again by himself, broke as when he started nearly ten years earlier, Dalio rebuilt Bridgewater Hedge Fund. Drawing from his painful lessons, he changed his management and investing approach, leading Bridgewater to become the top-performing hedge fund in the world.

Building Up Bridgewater Again: 1983-1994

How did Bridgewater Hedge Fund utilize computers and new technologies?

Computers and Automating Decision-Making

The development of microcomputers in the early 1980s gave Dalio even greater ability to turn his investment principles into automated rules. Working alongside a computer gave the team a few critical advantages:

  • Computers could collect much more data and crunch the numbers much faster. The team fed in financial datasets for every country possible, going back by more than a century. Computers could then back-test the investment rules against this historical data, showing how the strategies would have done in the past.
  • In real time, computers could produce trading decisions, more precisely and less emotionally than humans could.

But the computer didn’t work in isolation—the human and the computer worked alongside each other and improved each other. The human had imagination and logic that the computer didn’t, and he could introduce new rules. The human could also override the computer in unexpected situations, like September 11th.

To Dalio, trading alongside computers was like playing chess with a grandmaster standing behind him, helping him plot his moves. 

Automating trading reinforced logic over emotion, and it gave them an advantage in volatile times. Most people react emotionally to short-term fluctuations, buying when it’s hot and selling at a loss out of panic. In contrast, wise people stick with sound, timeless principles through the ups and downs.

Growing the Team and Business at Bridgewater Hedge Fund

Starting from just himself, Bridgewater grew to six employees by late 1983, ten people by the mid-1980s, and twenty by the end of the 1980s.

Bridgewater Hedge fund had three lines of business:

  • Selling their research and commentary on markets
  • Consulting for fees, teaching businesses how to speculate in ways that would help their core business
  • Managing investments directly and earning a portion of profits

Managing investments started as a small portion of their business, but it eventually grew to become the dominant arm of Bridgewater. This development made logical sense—Bridgewater’s research and consulting were making good calls that let their clients make money, so they figured they could successfully manage investments themselves.

Their first major account was a $5 million bond account from the World Bank’s pension fund. This was a turning point. Their success on this account gave them credibility to sign Mobil Oil and other accounts, eventually becoming the top-performing US bond manager. By the late 1980s, they were managing $180 million in investments. In 1990, they landed a $100 million account from Kodak’s pension fund, a huge boost to their credibility.

Pure Alpha: Diversification

After his crash in 1981, Dalio tried to find a way to enjoy high returns with low risk, rather than choosing just high-risk/high-reward or low-risk/low-reward. He wanted to have his cake and eat it too. 

He and his team had an epiphany: proper diversification could reduce risk without harming returns. The typical idea of diversification at the time was merely to diversify within an asset class. Instead of just holding a single stock, a fund manager might buy a hundred stocks. However, the stocks were still strongly correlated to each other. Therefore the portfolio of stocks was not all that well diversified—the stocks would generally rise together and fall together.

Bridgewater Hedge Fund found that the key was to add assets that were uncorrelated with each other. As a result of their systematic collection of investment principles across a wide range of asset classes, they could assemble a set of uncorrelated assets. Their models showed this approach would reduce the risk of a loss in any given year, without reducing overall returns. The result was a return-to-risk ratio that was multiple times better than their previous strategies, meaning they could make more money with lower risk of losing money. This was true diversification. Dalio called this the Holy Grail of investing.

Based on these principles, Bridgewater introduced a new fund called Pure Alpha. Even though the strategy wasn’t proven in practice, some clients believed in the concepts and invested. In the 26 years since the fund started, it made money in 23 years, and it’s made more money in total than any other fund ever.

The idea of diversification can be generalized, no matter what business you’re in: make a handful of uncorrelated bets to capture the upside without havingunacceptable downside

People Management at Bridgewater Hedge Fund

Dalio was stung by his overconfidence in the early 1980s. He now believed that the best way to be right was for smart people to disagree with each other and explore each other’s reasoning. He never failed to point out when other people were being dumb, and he expected others to do the same to him. He saw this like playing jazz together, going back and forth on ideas and building better decisions than individuals could alone.

There was mixed reception to this radical candor. People close to him, who had worked with him for years, understood he had good intentions. But people who had less contact with him found him abrasive and oppressive. He seemed like an intellectual bully, and his tirades were demotivating.

When his senior team delivered this feedback to him, Dalio was hurt. He had never intended to humiliate other people, and he realized there was a gap in communication. This friction kicked off his process of clarifying his principles in writing, so that everyone across the company could understand his intentions and behavior, and so everyone had a common set of rules to treat each other respectfully. 

In essence, he wanted to automate and systematize people management, much like he had automated financial trading.

Bridgewater Hedge Fund: A Fall Leads to New Ideas

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  • How Ray Dalio lost it all on bad bets, then rebounded to build the world's largest hedge fund
  • The 5-step process to getting anything you want out of life
  • Why getting the best results means being relentlessly honest with everyone you work with

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