Study the Past to Read the Present: Dalio's Methodology and Mental Models

Principles for Dealing with the Changing World Order is Ray Dalio’s newly published book, his third after Principles and Big Debt Crises.

The book analyzes the rise and fall of all the major empires and their currencies over the past 500 years, with particular focus on three: today’s most important American empire and the dollar, the previously most important British empire and the pound, and before that the Dutch empire and the guilder. It also examines six great powers that were important but relatively secondary in financial standing: Germany, France, Russia, Japan, China, and India. Of these six, it pays the most attention to China, reviewing Chinese history since the year 600.

From the history of the past 500 years, it distills a distinctive cycle model to explain the patterns by which the world’s major nations change in finance, economics, and social development, and by which the world order itself shifts.

Why should we study history? Study history to clarify your purpose; know the past to illuminate the present.

The reason people so often miss the important moments of growth in their lives is that each of us experiences only a small fraction of the long sweep of history. We are like ants, engrossed during our brief lives in carrying crumbs, with no time to broaden our view and discover the macro patterns and cycles by which things develop, the important connections behind them, where we stand within the cycle, and what may come in the future.

So in reading this book, you should learn not only its content, but the way that content is constructed. Below, I’ll discuss what I gained from reading it from three angles: methodology, mental models, and how it inspires my own work.

Methodology

Scientific Research

Dalio analyzes and distills patterns from vast amounts of data, then applies them to his own investment work—a process close to the method of scientific research, rather than, like many other people’s books, stopping at the sharing of experience and the chanting of slogans. This is why Dalio’s books have more reference and learning value.

Why do I feel his method is closer to the scientific one?

Because science does not tell you it can explain everything. True science tells you where its boundaries lie, what it cannot know. It is usually pseudoscience that tells you it can explain everything.

Throughout the book, Dalio stresses again and again: what I do not know far exceeds what I do know. His book keeps telling you where the boundaries of his knowledge lie, how he came to know what he knows, and what remains unknown to him.

What are the features of scientific research?

• First, the information it pursues appears in the form of publicly verified data—that is, its data are obtained under certain conditions, and other qualified people, under the same conditions, can carry out similar observations and obtain the same results.
• Second, the second major feature of the scientific method is control—the use of special procedures to reduce errors in observation and in the interpretation of research findings.
• Third, precision of language is the third major component of the scientific method. Many concepts are often unclear, vague, and ambiguous. The scientific method strives for precision and consistency in the use of language.

These features can be repeatedly verified in the course of reading this book.

The DIKW Model

As I read this book, I observed that its way of starting from vast data, sorting out useful information, distilling it into knowledge, and elevating it into wisdom, can be classified under the DIKW model, which shows the tiered, ascending relationship from data to wisdom.

The DIKW framework concerns Data, Information, Knowledge, and Wisdom. Each layer endows certain qualities beyond the one below. The data layer is the most basic. The information layer adds content. The knowledge layer adds “how to use it,” and the wisdom layer adds “when to use it.” The DIKW framework is commonly used in information science and knowledge management.

Their logical relationship is shown in the figure below.

My understanding of this model is: data are the various pieces of information received firsthand; after being filtered and refined, they become information (usable by you); a collection of information becomes knowledge, which can solve or judge a particular problem; and finally the linking of knowledge becomes wisdom—which can also be understood as a mental model. Master it, and you can solve N problems of the same kind.

Digital Assets

What sets this book apart is that it is “alive.” The website released alongside it, economicprinciples.org, offers—beyond the book’s content—more comprehensive analysis through additional charts and historical cases, and this content is continually updated and iterated. Once a book is published, updating it is slow and difficult, but a website’s content can be updated in real time. Through this digital approach, Dalio’s content gains stronger and more vivid life, offering a better way to construct and disseminate books in the digital age.

Mental Models

Evolution

Evolution is the greatest and only eternal force in the universe, yet we find it hard to notice.

“These historical studies have taught me that, apart from evolution, nothing is eternal. Within the process of evolution there are cycles that rise and fall like the tides, hard to change or resist.”

Evolution is the upward trajectory toward progress, and progress springs from adaptation and learning.

In Dalio’s first book, Principles, the thing that impressed me most was the diagram below. It can be applied to the process of continual iteration and upgrading—evolution—in any domain: investing, work, cognition, life. In this book, too, we can see Dalio repeatedly emphasizing this evolutionary method.

Cycles

“I noticed some major developments that had never happened in my lifetime, but had happened many times before in history.”

Dalio says that almost all investors talk about current events, but no one talks about these big cycles—yet the big cycles are the greatest driver of current events.

For example, Dalio studied the history of ten great powers since 1900. Of these ten countries, seven experienced at least one instance in which almost all their wealth was wiped out. Even those that did not experience the total loss of wealth went through several bad decades in which asset returns nearly destroyed their finances. In addition, two powerful developed countries (Germany and Japan, on which, in certain periods, it was easy to bet as winners) lost almost all their wealth and many lives in the two world wars. Many other countries had similar outcomes. The United States and Britain (and a few others) are among the rare success stories, yet even they went through periods of enormous wealth loss.

Only by studying history from a large enough vantage point—and looking toward the future through that lens—can we build a broader cognitive boundary for our own investments or for the continuation of family wealth.

Factors

Dalio summarized 18 key factors that determine the rise and fall of nations:

• Three important cycles: the long-term debt and capital-markets cycle, the internal order-and-disorder cycle, and the external order-and-disorder cycle.
• Eight major measures of power: (1) education, (2) competitiveness, (3) innovation and technology, (4) economic output, (5) share of world trade, (6) military strength, (7) financial-center strength, and (8) reserve-currency status.
• Additional determinants: geology; efficiency of resource allocation; acts of nature; infrastructure and investment; character/upbringing/determination; national governance and rule of law; and gaps in wealth, opportunity, and values.

With these factors in hand, we have clear analytical indicators; once we master them, we can also try to use them to analyze countries not mentioned in the book, or distill some indicators to analyze companies or families. Because at the level of mental models, much of the logic and method is transferable.

Takeaways

After reading this book, what does it offer for the family-office business we at Flourishing Tree are building?

A View of History

Achieving lasting family succession is a goal that spans generations, and we must view risk and opportunity from the vantage of long cycles of history. Let me first tell you the story of the “Five Tigers of the Rothschilds.”

The Rothschild family is a financial dynasty renowned in Europe and the world. It rose at the beginning of the 19th century, and its founder was Mayer Amschel Rothschild. Mayer sent each of his five sons to open a bank in one of five European financial cities. The eldest, Amschel, held the Frankfurt headquarters in Germany; the second, Salomon, opened a new front in Vienna in the Austro-Hungarian Empire; the third, Nathan, was dispatched to England to take charge of the overall situation; the fourth, Carl, went to Naples in Italy to build a base, and served as the courier shuttling among the brothers; and the fifth, James, ran the business in Paris, France. The Five Tigers of the Rothschilds, spread across five European financial centers, obtained more accurate and timely business information from one another through communication, and their capital acted in concert, forming a powerful combined force—thus raising the curtain on a financial empire unprecedented in human history.

I do not know whether Mayer, too, once studied history and knew that any country in history will experience the total or near-total loss of its wealth; but by dispatching his five sons to establish a financial map across five major countries, he undoubtedly spread the family’s risk. Later the Rothschild family went through the First and Second World Wars, and especially the Nazi persecution of the Jews (the Rothschilds are a Jewish family); only the British and French enterprises survived, and it was on the strength of these two surviving branches that they had the “principal” to rise again.

So when we discuss with Chinese entrepreneurs today how to achieve family succession and how to build a succession structure, whether we have a broad enough view of history and culture will, to a degree, determine whether the foundation we build is solid enough to support the “high-rise” of intergenerational succession.

A Factor Model

Just as Dalio has his 18 key factors for judging the rise and fall of nations, we at Flourishing Tree, through exploration and practice in the family-office business, have distilled a model of the family’s Six Capitals, using it as indicators to assess each year the “health” of the families we serve in their succession.

At the same time, we have created Flourishing Tree’s soft/hardware framework model for family succession (the Zhiqian system). We thus have a preliminary, systematic set of indicators in both framework and data, and—like Dalio’s evolutionary model—it is constantly being optimized and growing.

Workflow

Following Dalio’s working process in this book, we have organized our own workflow as follows:

1. Interact with this machine of history, trying to understand how it works.
2. Record our observations of how it works, and summarize the principles I have learned for responding.
3. Test the long-term applicability of these principles.
4. Turn these principles into models and methodologies to guide our family-office business.
5. Keep learning from experience, lessons, and reflection, further refining our principles.
6. Repeat this process endlessly.

Summary

Reading itself has almost no value. Value lies in the thinking after reading, the choice after thinking, and the action after choosing.

Every day, each of us faces a stream of situations to which we must react. Without principles, we would be forced to react in isolation to each of life’s unpredictable events, as if encountering them for the first time. But if we sort these situations into different types, and possess good principles for handling each type, we can make better decisions faster—and thereby live better lives.