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BRIDGEWATER

Dear XXXXXXXX, 2008 was a year to remember, so now is a good time to reflect on it and to extract the important lessons from it. Most importantly, it was a year in which a lot of mistakes occurred, so there is lots of learning and improvement that can come from looking at these mistakes analytically. It was a year in which all investors were stress–tested, and big differences surfaced, which are important to understand. It was also a year that has embedded in it lots of clues about the risks and opportunities that lie ahead, which we want to be sure to mine. So please indulge me while I attempt to do this reflecting in my usual circuitous and opinionated way. It seems to me that, above all else, what happened last year reflected human nature. No exogenous shocks caused what happened. The crisis was completely caused by people operating in a manner consistent with their individual natures and together in ways typical of group dynamics. In other words, people caused their circumstances, which they reacted to, which caused new circumstances that they reacted to, and so on. And they did this in ways that weren’t very complex or unique. For example, if you understand the game of Monopoly®, you can pretty well understand what happened to the economy and to people’s financial circumstances last year. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players have to give them cash. So, as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property that has lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So, early in the game “property is king” and later in the game “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes. Now let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it can make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. More money would be put into hotels sooner than it would be if there were no lending, the amount owed would quickly grow to multiples of the amount of money in existence, and the cash shortage for the debtors who hold hotels would become greater, so the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash caused withdrawals from the bank at the same time as debtors couldn’t come up with cash to pay the bank. That’s what happened in 2008. By the way, I suspect that, if the game of Monopoly® were played with the bank operating this way, and more kids played it from an early age, we would have more astute investors, businesspeople and bankers and, as a result, we would have less dramatic economic cycles. If we wanted to train our kids to have really rich appreciations of how the economy works, we would have to make our Monopoly® game only slightly more complex. Most importantly, we would allow the bank to print money. Really, that’s all that we’d have to do to make the game very realistic. But, if we really wanted them to become sophisticated global macro investors – i.e., to get them to learn about currency trading and “global macro” investing – we would have a few Monopoly® games going at the same time with each one having a different currency and allowing players to freely play in any or all of them.

Bridgewater Associates, Inc.  •  One Glendinning Place  •  Westport, CT 06880  •  203.226.3030 Tel  •  203.291.7300 Fax  •  www.bwater.com


If the bank could print the money, it would certainly do so when there was a cash shortage – i.e., when people need a lot of cash, when they can’t pay their debts, when they are selling their hotels, and when banks struggle to come up with enough money to meet demand, because the players aren’t servicing their debts. Our kids would soon learn that, all things being equal, printing more money causes its value (i.e., the currency) to fall and the increased money supply to buy hotels drives their prices up. But, if the bank prints more money when the demand for it is high, and there is a shortage of money when hotels are being dumped, and hotel prices are falling, then the currency would not fall in value and the prices of hotels would not rise, because the increased supply of money would simply negate the effects of the shortage of it. That’s also what happened in 2008. In other words, in the years immediately prior to 2008, players in the economy took on a lot of debt to buy assets at high prices, so in 2008 the game progressed to the stage where cash is in short supply, there are debt problems, and assets are written down or liquidated. Naturally, the central bank printed a lot of money, but this didn’t cause its value to fall or inflation to rise, because this increased supply of money negated some of the effects of the shortage. In Section II of the attached report, “A Template For Understanding What’s Going On”, we explain this debt/ economic dynamic in a more fleshed out way. If you only have a limited amount of time to read what we are sending, please stop reading this (and anything else that we gave you), and go read that. Because human nature and the basic elements of economics remain essentially the same over time, what happened in 2008 has happened many times before. However, unlike recessions that occur more frequently, the dynamic that occurred in 2008 has happened less frequently and has not happened within most people’s lifetimes. Because it is in most people’s “nature” to learn from their experiences, and because investors, businessmen, and government officials did not previously experience the dynamic that happened in 2008, most of them 1) did not plan for it, 2) considered it implausible, and 3) didn’t understand it. That, more than any other reason, is why so many of them were hurt in 2008. In other words, 2008 was a year in which those who built their strategies on the basis of what happened in their recent lifetimes did not understand what happened in 2008 and so did badly, while those who had a perspective of what happened in long ago times and faraway places (and why these things happened) did well. Said differently, if you optimize your investment strategy to work in a certain period without having a deep enough understanding of how it would work in all circumstances, including circumstances that did not occur within the period that’s your frame of reference, you will inevitably do very badly – and that is what happened to a lot of people in 2008. You have heard us speak of the importance of having a “timeless and universal” investment process, probably so much that you are sick of this phrase. What we mean by it is that we believe that one’s investment process needs to have worked well in ALL COUNTRIES AND ALL TIME FRAMES in order to continue to work as things change, because it must be based on essential truths that include understandings of how things change over time. We believe that, if investors don’t do this, their process will work until it inevitably doesn’t work (i.e., until it blows up), because things will inevitably change in ways that aren’t understood and incorporated into the process. So, in my opinion, 2008 was a very important year of differentiating those who operate this way from those who don’t. Since I believe that a big common mistake that caused many investors problems in 2008 was not having a broad enough perspective, I believe that one of the most important lessons for those who did badly in 2008 is to have a “timeless and universal investment” perspective, which means to broaden your perspective to understand what happened in long ago times (e.g., in the 1930s) and faraway places (like Japan and Latin America). Ask yourself, “what would it be like if we had another year, or another two years, like last year,” because an examination of history shows that this is well within the realm of possibilities. Nobody really knows what will happen, but we all need to consider the full range of possibilities, make sure that our strategies make the worst case scenarios tolerable (i.e., really control risk!) and look for ways to maximize our opportunities. Taking a timeless and universal perspective helps us to do that.

Bridgewater Associates, Inc.  •  One Glendinning Place  •  Westport, CT 06880  •  203.226.3030 Tel  •  203.291.7300 Fax  •  www.bwater.com


Another reason so many investors did badly in 2008 was that they had big, concentrated exposures to assets and portfolios that do well when the economy does well and badly when the economy does badly – and the economy did badly. They had these skewed exposures because: 1) The beta (i.e., asset allocation) exposures were not diversified; they were (and still are) typically much more heavily concentrated in assets that do well in good times and badly during bad economic times (e.g., public equities, private equity, real estate, high yielding debt, etc.) than in assets that do well in bad times (e.g., Treasury bonds). How did they get this way? It came about because of human nature – i.e., people are prone to do those things that worked in the past without thinking hard about why they worked or whether they will work in the future. In other words, investors are biased to invest in those assets that performed best during the timeframes that are in their frame of references. 2) The alpha exposures (i.e., tactical bets) were also typically not diversified and were (and still are) skewed to do well in good times and to do poorly in bad times. For example, the average “hedge” fund was (and still is) about 70% correlated with stocks. How did all these alphas and betas get so skewed toward doing well in good times and badly in bad times, and how is it possible that portfolios were so undiversified? And what happened to absolute returns in absolute return strategies? What happened occurred for the same reason – i.e., because of the tendency to do what would have worked in the past. So, alphas like betas became those strategies that worked in the recent past, which were strategies that worked in good times. 3) The risk and liquidity premiums effects on returns are correlated to the betas and the alphas in the portfolio. So when the economy did badly, these premiums rose and also hurt returns. So, all three major drivers of returns were prone to do well during good times and, as a result, the average institutional investor’s portfolio was (and still is) heavily skewed to do well in good times (e.g., over 90% correlated with equities) and to do poorly in bad times. And, since 2008 was a really bad time (i.e., economic conditions turned out worse than discounted), all the folks with these skews did badly. Since most everyone’s portfolios were skewed this way long before the 2008 price decline, and since the disaster scenario for this portfolio had happened in Japan where the stock market is still down about 70% from where it was 20 years ago, why weren’t investors concerned about the possibility that what happened to Japanese investors could happen to them? I believe that it is because of “human nature” – because their own experiences influenced their behaviors more strongly than this peripheral Japanese case. Having seen the most popular asset allocation mixes shift over time, I am confident that following a few bad years, new theories will emerge to justify why portfolios that are biased to do well during bad times are best – e.g., because they are good liability and funding hedges – and that most portfolios will be skewed this way. That is because it is human nature to believe that which has happened most recently is more likely to occur in the future, even though that belief is wrong. So, in reflecting on 2008 and the lessons for the future, I believe that one of the most fundamental questions investors should ask themselves is whether or not it is logical to have this huge bias to do well in times that are better than are discounted (i.e., to be so concentrated in assets and alpha strategies that are positively correlated with equities). Personally, I believe that having such huge biases is never logical, let alone at this time. So, I believe that another important lesson of 2008 for most investors is to avoid having systemic biases in your portfolio, which means to restructure your portfolio so that it is less vulnerable to any one environment by having better diversification between and within betas, alphas, and risk premiums. Before leaving this subject of risk premiums and the strong tendency for investors to believe that what happened in the past is likely to persist, I’d like to make one more point that pertains to them, in particular as to how they affect swings in fear and greed and how these swings affect pricing.

Bridgewater Associates, Inc.  •  One Glendinning Place  •  Westport, CT 06880  •  203.226.3030 Tel  •  203.291.7300 Fax  •  www.bwater.com


While investors tend to look at past returns as an indicator of future returns, all thing being equal, that’s backwards. That’s because high past returns typically cause assets to become more expensive, and, because of investors’ tendencies to buy after price increases for no good reason, prices tend to overshoot. And when investors are making money – which is typically after prices have risen – they’re greedy and fearless. And because investors buy assets on leverage when they are really confident and when the prices are really high, doing the opposite is a good idea. If, instead of looking at past returns, investors simply looked at yields, they would do the exact opposite and have much better results. In buying an investment, one is making a lump sum payment for a future income stream. The investment will make money if the present value of that income stream is more than the current price. So, to assess value, one has to estimate that income stream, take its present value and compare it to the price to assess its cheapness. If an investment has a higher yield, the growth rate of the income stream can be lower than if it has a lower yield. Said differently, when the investment has a high yield, less growth is discounted, so, all else being equal, it is more likely that the investment will have a higher return. So, buying assets when they have higher yields is better than buying them when they have lower yields. And if they are widely bought on leverage, the price will be higher than it would have been if there were no buying on leverage at the same time as leveraged investments are more susceptible to forced liquidations. So, one should be especially wary of investments that have low yields (therefore high prices) that are bought with leverage. Said differently, human nature causes reactive decision making that leads to psychological swings between fear and greed that is reflected in prices. In 2006-07 risk premiums became miniscule (so prices got very high) at the same time as leverage levels became enormous, so, in 2008, there wasn’t enough cash flow to pay debts, risk premiums increased, and prices fell, with the whole implosion process enhanced by mark-to-market accounting. Naturally, the Fed lowered interest rates to 0%. So, as we enter 2009, we see risk premiums up to levels that are about the same as in 1982 and nearly as high as in 1974, so they are near their U.S. post-World War II highs. However, the current risk premiums are still low (unattractive) in relation to where they were in the pre-WW II period (especially during 1932-33) and low relative to those in Japan and in Latin America in the worst of their crises. In other words, risk premiums are attractive if you believe that the future will play out the way it did in the U.S. post-World War II period and unattractive if you believe that it will play out in a manner that is similar to these other three cases. Also, there are a couple of important differences between conditions now and conditions in other times during the post-World War II period that are similar to the 1930s, Japan in the 1990s, and in Latin America in the 1980s. Most importantly, 1) debt service burdens are now higher than in the other post-World War II cases and more like those in these other three cases, and 2) monetary policy doesn’t control credit creation (because interest rates are near 0% as in the 1930s and in Japan’s case, and because of hyperinflation in Latin America’s case). Whether the path for the economy and the markets will be more like the paths in the post-World War II period or more like those in these other cases is a matter of conjecture that we will have to objectively and continuously assess based on how events transpire. So, in my opinion, in 2009, as in 2008, the most important driver of your portfolio’s returns: 1) that come from betas will be a) whether or not your beta mix (i.e. asset allocation) has the systematic bias to do well in good times or bad times and, if it does have a bias, b) whether or not we have bad times; and, 2) that come from your managers’ alphas will be a) whether or not they have systematic biases to do well in good times or bad times and, if they are not biased b) whether or not they can tell the difference between the good and bad times and position themselves to take advantage of whatever happens. Speaking of human nature, greed, and fear, I want to say a few words about character, because I believe it also played a big role in determining investors’ results and economic conditions in 2008, and that looking at how people acted can provide valuable lessons for the future. The greed that led to the bust was not just in the form of investors buying assets at high prices on leverage and driving risk premiums way down. It also came in the form of many investment managers who put making money for themselves ahead of doing what was best for their clients. This urge to make as much money as possible as fast as possible manifested itself in a range of ways and degrees, from downright cheating (e.g., in the case of Bernie Madoff), which happened in a small minority of cases, to being careless and not completely honest, which happened in the majority of cases. For example, I believe investment managers commonly slapped together tantalizing, unreliable investment products and described them to clients in less than totally accurate ways. And I believe that many investors naively didn’t perceive this deception or they accepted it as a reality that they had to try to protect themselves against while investing with these people. In

Bridgewater Associates, Inc.  •  One Glendinning Place  •  Westport, CT 06880  •  203.226.3030 Tel  •  203.291.7300 Fax  •  www.bwater.com


any case, investors commonly dealt with some managers whose character wasn’t at a high enough level. So, I believe that another important lesson should be to weigh character heavily in deciding whom to associate with. Just as you look at the length and quality of performance, look at the length and track record of character. In the investment business, there are both wonderful and terrible people, and everything in between, so character should be at least as important a factor in choosing your investment managers as past investment performance. Greed hurt the financial markets, the economy, investors, and even the perpetrators severely in 2008, so, if investors learn from this mistake, they will improve their results in 2009 and beyond. I have one last reflection about 2008 that’s an optimistic one. Periods like the one that we are in are an essential part of the cleansing, learning process that stress-tests people and processes and provides lessons that create improvements. So, in a very fundamental way, we, the markets, and the economy are now on sounder footing than during the boom. While we will inevitably get on a much sounder footing still, we will get there quicker if we and policymakers don’t make the typical mistakes that investors and policymakers have made in similar circumstances in the past. Along these lines, I am very pleased to say that I think that the top people on the Obama economic team are stars, and I have the utmost admiration for the way the Fed is now being managed. So, I believe that the country has a team of great doctors working on a very serious disease that will eventually end and will inevitably leave the markets, the economy, and us on a more sound footing. Of course, that doesn’t mean that all people will eventually be OK. As part of this evolutionary process, there will be great risks and opportunities that will lead to the survival of the fittest. As with all such evolutionary processes, this will eventually be great for the whole, though it will certainly be deadly for some. In closing I want to thank you again for allowing us to be in this fight with you and to assure you that we will continue doing everything in our power to do our best for you. Most importantly, I wish you and your loved ones health in the New Year,

Ray Dalio

Bridgewater Associates, Inc.  •  One Glendinning Place  •  Westport, CT 06880  •  203.226.3030 Tel  •  203.291.7300 Fax  •  www.bwater.com


Ray Dalio's (Bridgewater Associates) Annual Letter to Clients