First: Here’s an excerpt from Ray Dalio’s recent book Principles recounting his biggest aha!” moment in investing (emphasis is mine).

This is an important concept to understand.

Diversifying with over 15 uncorrelated return streams and balancing out your return per unit of risk, through sizing and leverage (ie, leveraging bonds to equal equity on a return per risk unit basis), can get you to a balanced global or market-neutral position.

This is where your risk is balanced out and you’re effectively clipping beta coupons from global markets and various asset classes.

An important note I should make is that to build this market-neutral book you really have to understand cross-asset correlation. It’s not correlation in the typical sense, where you use a market lookback period of say three years to see how much in line those asset classes have moved together.

The correlation has to do with the fundamental drivers of each asset class (ie, what are the economics that drive investors to buy and sell each asset class). At its most basic, this idea can be boiled down to two inputs of growth and inflation which when combined give you four stages.

Different asset classes will perform well in some stages and less well in others, as the graph to the right shows.

You can dive really deep into this and begin to do some interesting stuff — I’ll save that for another post on another day.

But, as a trader, I love the idea of having a market neutral book that collects beta in a smart risk-adjusted way.

This gives me an excellent base from which to operate off of and build an alpha overlay by making what are typically low probability but high expected value (EV+) convex bets, preferably using leverage on top of my beta.

This takes the pressure off me as the trader to always be in the market with a position and allows me to focus my time on seeking out the fat pitches and asymmetric trades that only come around every so often.

I’ve long been a proponent of the old-school macro approach used by Soros and Druck where you’re highly concentrated. You have just a few eggs in your basket that you watch intensely. But a more optimal approach is a combination of the two. Use diversification to collect your beta and overlay that with a concentrated book for your alpha.