The most underrated chapter in Dalio's "Principles": About the big cycle, he explained it three years ago.

Author: Ray Dalio

Translation: Deep Tide TechFlow

Deep Tide Introduction: This article has received 75 million views and is Chapter 2 of Ray Dalio’s book Principles: Life and Work, focusing on how to allocate investment portfolios within a long-term cycle framework.

Dalio uses real historical data to reveal an unsettling fact: over the past century, seven out of ten major great powers have had their wealth nearly wiped out at least once — and most investors have never studied this history. In the current era of increasing global order friction, this analytical framework’s reference value far exceeds that of typical macro commentary.

The full text is as follows:

Last week, I shared a chapter from my 2021 book Principles: Life and Work, which details the classic signals and evolution processes to watch for during the disintegration of the world geopolitical order within what I call the “Great Cycles.” This article was very popular, garnering over 75 million views, and many asked what it means for investing.

Because of the many inquiries, I am now sharing the next chapter of the book — Investing in the Great Cycles. I believe it offers valuable perspectives for current investments. You can read the full chapter below.

Additionally, since many are interested in my investment principles, I will be sharing them gradually over the next few weeks. If you want to receive notifications of new posts, please subscribe to my newsletter Principled Insights or sign up for email alerts.

My approach to life and career is to try to understand how the world works, develop guiding principles accordingly, and then position myself accordingly. The research I share in this book is precisely for that purpose.

Naturally, when I review everything involved up to this point, I think about how to apply it to investing. To be confident in my approach, I need to understand how my methods would have performed historically. If I cannot confidently explain what happened in the past, or at least have a strategy to handle the unknown, I consider that a dangerous oversight.

As my research over the past 500 years shows, history features cycles of massive wealth and power accumulation and loss, with debt and capital market cycles being the most significant contributors. From an investor’s perspective, this can be called the “Major Investment Cycle.” I believe it’s essential to fully understand these cycles so that I can tactically shift or diversify my portfolio to hedge against or profit from them. By understanding these cycles and, ideally, judging where each country stands within its cycle, I can achieve this.

Over my approximately 50-year global macro investing career, I have discovered many universal truths across time and regions that form my investment principles. While I won’t delve into all principles here — most will be discussed in my next book Principles: Economics and Investing — I want to convey an important principle.

All markets are driven by four main factors: growth, inflation, risk premiums, and discount rates.

This is because all investments are essentially exchanges between a one-time payment today and future payments. Future cash flows are determined by growth and inflation; the risk premium reflects how much risk investors are willing to bear compared to holding cash; and the present value of those future payments is determined by the discount rate.

Changes in these four factors drive changes in investment returns. If I know how each of these will evolve, I can predict how investments will perform. Understanding this allows me to connect what’s happening in the world with market movements, and vice versa. It also shows me how to balance my investments, ensuring the portfolio isn’t biased toward any particular environment — which is the essence of good diversification.

Governments influence these factors through fiscal and monetary policies. The interaction between what governments expect to happen and what actually occurs is the engine behind cycles. For example, when growth and inflation are too low, central banks create more money and credit, boosting purchasing power, which initially accelerates economic growth, followed by rising inflation (with a lag). Conversely, when central banks restrict money and credit growth, the opposite occurs: economic growth and inflation slow down.

The actions of the central government and the central bank differ. The government decides where its funds come from and go — through taxation and spending — but cannot create money and credit. The central bank can create money and credit but cannot decide which sectors these funds enter. Their actions influence the buying and selling of goods, services, and investment assets, pushing prices up or down.

To me, each asset class reflects these driving factors in its own way, consistent with how they impact future cash flows. Each asset is a component of the portfolio, and the challenge is to combine them rationally, considering these factors.

For example, when growth exceeds expectations, stock prices may rise if other conditions remain unchanged; when growth and inflation are higher than expected, bond prices may fall.

My goal is to assemble these modules into a balanced, diversified portfolio that is tactically tilted based on current or anticipated impacts of these four factors. These modules can be broken down by country, environment preferences, industry, and individual companies. When applied to a balanced portfolio, the effect looks like the diagram below. This is the perspective I use to analyze historical events, market history, and portfolio behavior.

I know my approach differs from most investors for two reasons. First, most investors do not seek historical analogs because they believe history and past returns are largely irrelevant to them. Second, they do not view investment returns through the lens I just described. I believe these perspectives give me and Bridgewater a competitive advantage, but whether to adopt them depends on you.

Most investors set expectations based on their lifetime experiences; fewer are diligent enough to review history and see how their decision rules would have performed in the 1950s or 1960s. Among the investors I know — including top economic policymakers — none have an excellent understanding of what happened in the past and why. Most long-term return data are based on the US and UK (which won both World Wars), making these countries seem representative.

This is because few stock and bond markets survived after WWII. But these countries and periods are not representative, due to survivor bias. Looking at US and UK returns is examining the luckiest countries during the best parts of the long cycle. Ignoring other countries and earlier periods creates a distorted view.

Starting from what we know about the long cycle, extending the view forward by decades and examining different regions reveals a startlingly different perspective. I will demonstrate this because I believe you should understand it.

In the 35 years before 1945, nearly all wealth in most countries was destroyed or confiscated. In some countries, when capital markets and capitalism collapsed along with other aspects of the old order, many capitalists were killed or imprisoned — driven by anger against them.

If we look back over the past few centuries, we see such extreme boom/bust cycles occurring regularly — periods of prosperity for capital and capitalism (like the late 19th and early 20th-century Second Industrial Revolution and Gilded Age), followed by transitional periods (like the 1900s-1910s with internal conflicts and international power struggles), leading to major conflicts and economic depressions (similar to those between 1910 and 1945).

We can also see that the causal relationships behind these boom and bust periods are now more akin to the depressions and reorganizations at the cycle’s end, rather than the early periods of prosperity and growth.

My goal is simply to observe and understand what happened in the past, then do my best to show it to you. That’s what I am attempting now. I will start from 1350, even though the story began long before that.

The Long Cycles of Capitalism and Markets

Around 1350, charging interest on loans was prohibited by Christianity and Islam — also forbidden within Jewish communities — because it caused serious problems: human nature led people to borrow beyond their ability to repay, creating tension and often violence between borrowers and lenders. Due to the lack of lending, money was “hard currency” (gold and silver). About a century later, during the Age of Discovery, explorers traveled the world collecting gold, silver, and other hard assets to accumulate more wealth. This was the main way wealth was accumulated at the time. Explorers and their sponsors shared profits, creating an effective incentive-based wealth system.

The modern concept of lending magic — the creation of credit — was first developed around 1350 in Italy. Lending rules changed, and new forms of money emerged: cash deposits, bonds, and stocks, very similar to what we know today. Wealth became promises to pay in currency — what I call “financial wealth.”

Think about how much impact the invention and development of bond and stock markets had. Before that, all wealth was tangible. Imagine how much more “financial wealth” was created by these markets. To grasp the difference: if your cash deposits and future promises from stocks and bonds didn’t exist, how much wealth would you have now? Almost nothing — you’d feel bankrupt and behave differently — for example, saving more tangible assets. That was roughly the state before the creation of cash deposits, bonds, and stocks.

With the invention and growth of financial wealth, money was no longer tied to gold and silver. Because of money, credit, and purchasing power, less and less was constrained, and entrepreneurs could start companies, borrow, and sell shares to raise funds. They could do this because promises to pay became entries in ledgers — forms of currency.

Around 1350, those who could do this — most famously the Medici family in Florence — could create money. If you could create credit — say, five times the actual money (which banks could do) — you could generate enormous purchasing power, reducing the need for other types of money (gold and silver). The creation of new money was, and still is, a form of alchemy. Those who could create and use it — bankers, entrepreneurs, and capitalists — became very wealthy and powerful.

This process of expanding financial wealth has continued to this day, to the point where tangible assets like gold, silver, and real estate have become relatively less important. But of course, the more promises in the form of financial wealth, the greater the risk that these promises cannot be fulfilled. This is the root cause of classic debt/money/economy cycles. Think about how much financial wealth exists today relative to real wealth, and imagine you and others holding this financial wealth trying to convert it into real wealth — selling it to buy goods. It’s like a bank run. This cannot happen. The value of bonds and stocks relative to what they can buy is too large. But remember, under a fiat currency system, central banks can print money to meet demand. This is a universal truth across time and space.

Also remember, paper money and financial assets (like stocks and bonds), which are essentially promises to pay, are of little use in themselves; what matters is what they can buy.

As discussed in Chapter 3, when credit is created, purchasing power is created along with the promises to pay, providing short-term stimulus but long-term restraint. This creates cycles. Throughout history, the desire to acquire money (through borrowing or selling stocks) has been symbiotic with the desire to store money (through lending or investing in stocks). This leads to growth in purchasing power, ultimately creating payment promises far exceeding deliverable assets, resulting in crises of default, such as debt defaults, depressions, and stock market crashes.

At those times, bankers and capitalists were literally and figuratively hanged, vast wealth and lives were destroyed, and large amounts of fiat currency (printable but valueless money) were issued in attempts to alleviate crises.

From an investor’s perspective, the full picture of the long cycle

While it’s too burdensome to review all relevant history from 1350 to now, I will show what would have happened if you had invested starting in 1900. But first, I want to explain how I view risk, because I will emphasize these risks in the following.

To me, investment risk is not just volatility measured by standard deviation — although that is almost exclusively used — but the risk of not earning enough to meet your needs.

Most investors face three main risks: their portfolio doesn’t generate enough returns to cover expenses; their portfolio faces destruction; and most of their wealth is confiscated (e.g., through high taxes).

While the first two seem similar, they are different because it’s possible to have high average returns but suffer one or more catastrophic losses.

To gain perspective, I imagine myself being thrown into 1900 and examine how my investments would have performed each decade since then. I focus on the ten most powerful countries at that time, skipping less developed nations more prone to bad outcomes. Any of these countries could have become or been a great empire of wealth; they are all reasonable investment locations, especially when seeking diversification.

Among these ten countries, seven experienced at least one near-total wealth destruction — even those that didn’t see wealth wiped out still experienced decades of terrible asset returns, nearly leading to financial ruin. Two major developed countries — Germany and Japan — are often seen as likely winners, but in both world wars, nearly all wealth was destroyed, and many lives lost. I see similar results in many other countries. The US and UK (and a few others) are particularly successful cases, but even they experienced periods of massive wealth destruction.

If I hadn’t reviewed the returns before 1945, I wouldn’t see these destructive periods. Without looking at the last 500 years globally, I wouldn’t see how these events recur in nearly every place.

The numbers in the table show the annualized real returns for each decade, meaning losses over the decade are roughly eight times the number shown, and gains about 15 times.

Perhaps the chart below provides a clearer picture, showing the proportion of major countries holding a 60/40 stock/bond portfolio that experienced losses over five-year periods.

The table details the worst cases of investment in major countries. You’ll notice the US isn’t on this list because it didn’t experience a prolonged period of losses. The US, Canada, and Australia are the only countries that didn’t go through sustained downturns.

Naturally, I think about how I would have responded during those periods. I can say with certainty that even if I saw signs of what I’ve conveyed in this book, I would never confidently predict such terrible outcomes — as mentioned, 7 out of 10 countries saw their wealth wiped out. In the early 20th century, even those reviewing the past decades would never have foreseen this, because based on the second half of the 19th century, there was ample reason to remain optimistic.

Today, people often assume that the outbreak of World War I was predictable in the years before, but that’s not true. Before the war, the major powers experienced nearly 50 years of relative peace. During that time, the world saw unprecedented innovation and productivity growth, bringing enormous wealth and prosperity.

Globalization peaked, with exports increasing several times over the 50 years before WWI. Countries were more interconnected than ever. The US, France, Germany, Japan, and Austria-Hungary were rapidly rising empires, experiencing dizzying technological progress. Britain remained the dominant global power. Russia was rapidly industrializing.

Among the countries with the worst investment records, only China was clearly in decline. The strong alliances among European powers at the time were seen as means to maintain peace and balance of power. By 1900, everything looked good, except for growing inequality and resentment, and debt had become large. Between 1900 and 1914, conditions worsened, and international tensions escalated — leading to the terrible return periods I described earlier.

But the situation was worse than those returns.

Moreover, wealth confiscation, confiscatory taxes, capital controls, and market closures had huge impacts. Most investors today are unaware of these events, believing they are impossible because they don’t see them in recent decades. The table shows when these events occurred. Naturally, the most severe cases of wealth confiscation happened during periods of high inequality, economic deterioration, internal conflicts over wealth, and/or war.

The next chart shows how the proportion of stock market closures in major countries has changed over time. Wartime closures are common, and communist countries also closed their markets for over a generation.

All the bad cycles before 1900 were just as bad. Worse, these periods of internal and external struggles over wealth and power led to massive deaths.

Even for investors in countries that won wars (like the US, which was the biggest winner twice), there are two additional hurdles: market timing and taxes.

Most investors sell near lows because they need money and panic; they buy near highs because they have ample funds and are driven by euphoria. This results in worse actual returns than the market averages I’ve shown. Recent studies indicate that from 2000 to 2020, US investors underperformed US stocks by about 1.5 percentage points annually.

Regarding taxes, the table estimates the average impact of taxes on all 20-year investments in the S&P 500 (using the highest quintile income tax rate today during the entire period). Different columns represent different ways of investing in US stocks, including tax-deferred retirement accounts (taxes paid only at withdrawal) and regular brokerage accounts where dividends are taxed annually and capital gains are taxed at 20% at the end of the period, with losses offsetting gains.

While these approaches have different tax implications (retirement accounts being least affected), all show significant impacts, especially on real returns, as taxes can erode a substantial part of gains. On average, US investors lose about a quarter of their real stock returns to taxes over a 20-year period.

Reviewing Major Market Cycles

Earlier, I explained how classic debt and capital market cycles work. To reiterate: during the upward phase, debt increases, and financial wealth and obligations relative to tangible assets rise until these future promises (cash, bonds, stocks) can no longer be fulfilled.

This leads to “bank run” style debt problems, prompting money printing to try to prevent defaults and stock crashes, which causes currency devaluation, a decline in financial wealth relative to real assets, until the real (inflation-adjusted) value of financial assets becomes cheap again. Then the cycle resets.

This is a simplified description, but you get the idea — during the downturn, real returns on financial assets are negative relative to real assets, and the era is tough. This is the anti-capitalist, anti-capitalism cycle phase, lasting until it reaches the opposite extreme.

This cycle is illustrated in the following two charts. The first shows the total value of financial assets relative to real assets. The second shows the real return of cash (i.e., inflation-adjusted). I use US data rather than global data because it’s the most continuous since 1900. As you see, when financial wealth greatly exceeds real wealth, it reverses, and the real return on financial assets (especially cash and debt assets like bonds) becomes very poor.

This is because debt holders’ interest rates and returns must stay low to provide relief for heavily indebted borrowers and to stimulate more debt growth. This is the classic late stage of a long debt cycle.

It occurs when more money is printed to ease debt burdens and new debt is created to increase purchasing power. This causes money to depreciate relative to other stores of wealth and goods/services.

Eventually, as financial asset values decline and become cheap relative to real assets, reaching the opposite extreme, the cycle reverses, and peace and prosperity return, entering an expansion phase with strong real returns on financial assets.

As mentioned earlier, during periods of currency devaluation, the value of hard assets and hard currencies relative to cash rises. For example, the next chart shows periods when the value of a classic 60/40 stock/bond portfolio declined, coinciding with rising gold prices. I am not claiming gold is a good or bad investment; I am simply describing the economic and market mechanisms and how they have manifested in past market movements and returns, to share my perspective on what has happened, what might happen, and why.

Investors should regularly ask themselves: Is the interest paid enough to compensate for the risk of depreciation?

The classic debt/money/market cycle repeats across history, as shown in the charts, manifesting as:

1. The relative value of tangible currency and tangible wealth

versus

2. The relative value of financial currency and financial wealth. Financial currency and wealth are only valuable if they can exchange for real, intrinsic-value currency and real wealth.

These cycles always operate this way: during the upswings, the amount of financial currency and wealth (debt and equity assets created) increases relative to the amount of tangible currency and tangible wealth they represent.

This increase is driven by:

a) Profitable activities of capitalists creating and selling financial assets;

b) Policy makers’ effective means of creating prosperity by injecting money, credit, and other capital market assets to fund demand;

c) When the book value of financial investments rises due to declining currency and debt asset values, it creates an illusion of greater wealth. In this way, governments and central banks have historically created financial claims far exceeding what can be exchanged for real wealth and real currency.

During the uptrend, as interest rates fall, stock, bond, and other asset prices rise because lower rates tend to push up asset prices if other conditions are equal. Simultaneously, injecting more money into the system increases demand for financial assets, reducing risk premiums.

As these investments rise due to falling rates and more money in the system, they appear more attractive, while interest rates and expected future returns on financial assets decline.

The more claims relative to the underlying assets, the greater the risk. This should be compensated by higher interest rates, but often isn’t, because conditions seem good, and memories of debt and market crises fade.

The charts I previously showed to illustrate cycles cannot be complete without some interest rate data. These are in the next four charts, tracing back to 1900. (Note: this chapter was first published in 2021; the charts below include data up to that year.)

They show real (inflation-adjusted) bond yields, nominal (not inflation-adjusted) bond yields, and nominal and real cash interest rates in the US, Europe, and Japan. As you can see, they were much higher in the past and are now very low.

At the time of writing, real yields on reserve currency sovereign bonds are near historic lows, nominal yields around 0%, also close to historic lows. As shown, real yields on cash are even lower, though not as negative as during the massive printing periods of 1930-45 and 1915-20. Nominal cash yields are also near all-time lows.

What does this mean for investing? The goal of investing is to store wealth in a means that can be converted into purchasing power later. When investing, you exchange a lump sum today for future payments.

Let’s see what this looks like as of this writing. If you invest $100 today, how many years will it take to get back your $100, and then start earning on your principal? In bonds in the US, Japan, China, and Europe, you might need about 45, 150, and 30 years, respectively, to recover your money (likely with low or zero nominal returns), and in Europe, with negative nominal rates, you might never recover your principal.

But since you’re trying to store purchasing power, you must consider inflation. As of this writing, in the US and Europe, you might never regain your purchasing power (in Japan, over 250 years). In countries with negative real interest rates, you will almost certainly have much less purchasing power in the future.

Instead of earning returns below inflation, why not buy something — anything — whose value equals or exceeds inflation? I see many investments I expect will significantly outperform inflation. The chart below shows the recovery periods for holding cash and bonds in the US, in nominal and real terms. As shown, this is the longest in history — an obviously absurd period.

Conclusion

What I am presenting here is the view of the long cycle from the investor’s perspective since 1900. When reviewing 500 years of global history and 1,400 years of Chinese history, I see the same fundamental cycles recurring for the same fundamental reasons.

As discussed earlier, the terrible periods before 1945, when the new world order was established, are typical late-stage features of the long cycle, during which revolutionary changes and reorganizations are happening. While these periods are terrifying, they are far worse than the astonishing upward phases that follow the painful transition from the old order to the new. Because these events have happened many times before, and I cannot predict what will happen next, I cannot invest without safeguards against these events and protections against my own misjudgments.

Footnotes

[1] The discount rate is the interest rate used to evaluate the present value of future money. It is calculated by comparing how much money invested today at that rate (the discount rate) will be worth in the future to equal a specific amount.

[2] If the government and its system collapse, non-governmental forces will take over — a story I will not delve into here.

[3] You can see this alchemy at work today in digital currencies.

[4] When compounding over ten years, gains outweigh losses because you keep accumulating on gains; when experiencing losses near zero, future percentage losses have less impact in dollar terms. Comparing annualized gains and losses represents compounding from an average 10% annual return and -5% annual loss. In more extreme changes, the multiplier begins to shift.

[5] For China and Russia, bond data before 1950 are modeled based on hard currency bond returns, assuming hedging against local currency; stocks and bonds during revolutions are modeled as complete defaults. The annualized return assumes a full 10-year period, even if markets closed during that decade.

[6] Poor asset return cases in smaller countries like Belgium, Greece, New Zealand, Norway, Sweden, Switzerland, and emerging markets are not included here. For simplicity, only the worst 20-year windows are shown (e.g., Germany 1903-1923, excluding 1915-1935). For our 60/40 portfolio, we assume rebalancing monthly within these windows.

[7] Although not exhaustive, I list examples where clear evidence shows these events occurred within a 20-year span. Wealth confiscation is defined as large-scale expropriation of private assets, including government (or revolutionary) forced non-economic sales. Capital controls are significant restrictions on moving funds into or out of countries and assets (excluding targeted measures like sanctions).

[8] The tax impact on 20-year investments in the S&P 500 is calculated at a 26% rate (the highest quintile effective federal rate in 2017). Different columns show different investment methods, including tax-deferred retirement accounts (taxed only at withdrawal) and taxable brokerage accounts where dividends are taxed annually and capital gains at 20%, with losses offsetting gains.

[9] Based on the 30-year nominal bond yield level as of August 30, 2021 (considered a perpetuity).