The barbell investing strategy, advocated by Nassim Taleb, can take many forms and may be structured in such a way that some of the holdings take significant (well above average) advantage of market movements, while another part of portfolio is very low risk and isn’t affected by major market moves. Another type of barbell portfolio is to include assets that fall on opposite ends of a chosen spectrum.
Written by: Jiva Kalan
Nassim Taleb is a world-renowned statistician, trader and author whose primary research and experience lies in randomness, probability, and uncertainty. Born in Lebanon, Taleb earned his undergraduate, masters, and Ph.D. from The University of Paris. Upon immigrating to the United States, Taleb received an MBA from the Wharton School of Business at the University of Pennsylvania.
Over his lifetime Taleb authored several books, his most famous book, “The Black Swan,” earned recognition as one of the most influential books in recent history. Other works by Taleb include “Fooled by Randomness” and “Antifragile,” which are worthwhile reads for any investor.
In his books, Taleb is an advocate of the barbell investing approach. Having found great success as a trader, Taleb profited several times throughout his life on market downturns when most investors were taking losses, reportedly profiting during the 2008 financial crisis from the implementation of a barbell investing strategy. Funds operated by Taleb gained as much as 115% during the financial crisis by utilizing barbell strategies. That said, barbells can also be set up to profit more during rising markets.
The Basic Concept of the Barbell Portfolio Strategy
Imagine a bodybuilder in the gym, doing bicep curls with a pair of weights. What does the barbell they are using look like? Can you see it?
The barbell portfolio is similar to that physical barbell. A real-life barbell has weights on each end and a bar in the middle to connect them. With an investing barbell, on one side you could have investments that are high risk but have a high reward potential. On the other side, you have investments with low risk and low reward potential. No investments are held in the middle, or in other words, nothing medium risk or “average” is held in the portfolio.
The barbell portfolio can be used in equity markets, and may even utilize options (but doesn’t have to), which will be discussed shortly. The barbell approach is also widely used by investors in the bond market. A barbell portfolio in the bond market would consist of long-term bonds on one side, stacked against short-term bonds on the other end of the portfolio. In this scenario, there would be no medium duration bonds. A barbell bond portfolio must be actively managed since the short-term bonds will need to be continually rolled over into other bonds with similar duration.
In an equity portfolio utilizing a barbell strategy, just as a general example for demonstration purposes, the portfolio could be stacked with equities that have high betas and are aggressive in nature, while the other half of the portfolio would consist of low beta defensive equities, or even treasuries or some other very low risk investment. Potential issues with this, and alternatives, will discussed later on. The point is to show the stark difference between one end of the barbell and the other.
Beta is a measure of how much a stock moves relative its index, such as the S&P 500 for most stocks, or gold for a gold stock. For example, if the S&P 500 goes up 10% and a stock goes up 20%, and this relationship tends to hold true over time, it would have a beta of roughly 2…it moves twice as much as the index. This would be an example of a high beta stock. A stock with a low beta, say of 0.35, means that stock only moves about 35% as much as the index So if the index is up or down 10%, the stock may only rally or drop by 3.5%. On the S&P 500, only 10% of companies have betas (1 year) of less than 0.5 and only 10% have betas above 1.59. These numbers may fluctuate slightly over time.
Betas can also be negative. A negative beta indicates the asset typically moves in the opposite direction of the index, to the magnitude indicated by the beta number (correlation studies can help confirm this). Depending on how the barbell is constructed, negative beta stocks may be of use, since they they may well go up if a major stock market crash occurs.
Beta is available on most stocks, and is calculated by many sites including Finance.Yahoo.com. Type in a stock in the quote box, and Beta is provided in the summary window.
Another example of a barbell stock portfolio could be to buy the 10 worst performing stocks in the S&P 500, and the 10 best. You have two extremes, with nothing in the middle. Between 1991 and 2015 this strategy actually produced double the return of simply buying an S&P 500 index fund. Just like with the other barbell approaches, no “average” stocks are bought, only the ones on the performance fringe.
For investors that are more worried about crashes, and want to capitalize if that happens, they could put a large portion of their funds in low risk assets, like short-term bonds or treasury bills, and then a small portion of their capital into put options or assets that would resemble a put option (that will benefit greatly if something unexpected occurs).
Taleb doesn’t come out and say what you should put in your barbell, especially when it comes to the high risk/reward side of the portfolio. This he leaves up to you. Which means figuring out how you will take greater advantage of big market upswings (high beta, possibly), or how you will capitalize on or protect yourself from market downswings. This takes some thinking, as you could essentially create infinite barbell combinations and strategies by picking investments on opposite ends of the spectrum from each other.
The opposite of a barbell portfolio is a bullet investment strategy. For equities, the bullet would be like buying an index fund or a sector fund, where the investor is just trying to get an average return from a set of specific assets. They get average returns in up years and average losses in down years (average meaning the index return). As for a bullet investing strategy for bonds…the bonds in the portfolio have the same (or very close) maturation date. This works well if the investors know they will need their capital back at a certain point in the future.
Why Use the Barbell Portfolio?
The argument goes something like this: no one can predict where the market is going, so you should not even try. There are a few things you do know, however. In the long run, the market tends to go up. Also, downturns or crashes occur from time to time–periods of time when stocks fall in value. What you can do, is allocate your portfolio in such a fashion that you gain more heavily during the good times so that over the long-run the downturns don’t hurt as much. Alternatively, and likely to be less used by the everyday investor, is to set up the portfolio to profit handsomely when crashes or “Black Swan” events occur. An example of this approach will be discussed below.
Black Swans refer to rare events. It goes back to a time when people held the belief that the only types of swans that existed in the world were white swans. The Black Swan then, when sighted, would shake the foundations of any man who believed only in white swans.
Nassim Taleb took that idea and ran with it, applying it to the world of finance and investing. In this context, a black swan is an event that is an outlier, its occurrence unpredictable and its impact beyond the scope of everyday expectations.
The 2008 financial crisis is an example of a “Black Swan” event. Leading up to the crisis, many financial analysts and “quants” built models that associated the probability of loss or gain to various investments according to a few assumptions. Sometimes these models hinge upon the idea that investing returns are normally distributed, or exist on a bell curve.
Taleb argues that it would be a mistake to make that assumption. The proper distribution has what is known as “fat tails.” What this means, in plain language, is that the likelihood of extreme events (like a 2008 recession) are far more likely than would be predicted if we assumed that returns were normally distributed. When these extreme events eventually occur, investors are caught off-guard, are unprotected, and end up losing substantial amounts.
Taleb argues that Black Swans are inevitable, unpredictable, and when they occur, your losses will be far greater than you ever imagined. In a barbell portfolio, the investments with low risk weather the financial storm better than the high risk names, helping to preserve capital, but the high risk names also produce higher returns when things are going well (since each portfolio is different, it is up the investor to make sure the high risk names they own actually have a good chance of producing the big returns required for the strategy to pay off). Unfortunately, these high risk stocks are prone to wild price swings during market declines, and may witness substantial declines themselves. An alternative is to use options contracts or negative beta stocks/ETFs to hedge against or profit from market downturns.
Universa fund, advised by Taleb and operated by Mark Spitznagel, reportedly went from just over $300 million under management to $2 billion in assets in the first year of operation. The fund launched in 2007, so those gains accrued during the heart of the financial crisis.
The barbell strategy utilized by Universa was to keep 90% of its assets in stable assets with a low beta such as cash and treasury bonds. The other 10% of the portfolio was spent on far out of the money puts. In a market downturn, these contracts would allow Universa to reap huge rewards. They pay a little for the luxury, but no doubt considered it an insurance payment. The firm did take small losses when the market was trending upwards, but when the inevitable black swan event occurred, Universa profited wildly. When those events don’t occur, though, the fund accrues small losses, and over the long-run it is yet to be determined if it will beat the averages. Estimates put the profits for clients in 2008 somewhere near 100%, potentially up to 30% in 2011, up to 20% in 2015 and small losses in other years.
Individual investors could utilize a similar approach, investing a large chunk of their portfolio in low risk investments, a portion in high beta stocks that profit handsomely during the good times, and then buy put options with a small portion of the portfolio to protect/hedge and potentially even massively profit a sizable market downturn. Such a strategy would require a fair bit of active management, especially when it comes to continually buying new puts as they expire, and would also require a skill in terms of what options and stocks to buy, and in what quantities and allocations. How a person does that depends on their goals, investment horizon, risk tolerance and their knowledge level.
Alternatives to the Barbell Portfolio
The barbell portfolio works for some people, but isn’t for everyone.
If it all sounds too complicate, follow Warren Buffett’s advice and just invest in a lost-cost index funds like the S&P 500 SPDR (SPY): “I think it’s the thing that makes the most sense practically all of the time….Keep buying it through thick and thin, and especially through thin.” This is the best advice for newer investors who want to get their feet wet and likely make money over the longer-term.
Another investment strategy is the CAN SLIM trading method, which is typically a bit shorter-term in nature, and attempts to capture major price swings in strong stocks that are moving well.
Buying good stocks at a good price is the basis for the Magic Formula investing strategy, where traders buy the best stocks at the best price each year.
There isn’t a single way to invest, and not every method is right for every person. The important thing is finding something that resonates with you, and that allows you to sleep at night.
Final Word on Barbell Investing
The barbell investing strategy is utilized by and promoted by a number of successful investors, including the statistician and investor Nassim Taleb. He has devoted his life to randomness, probability and hedging against–and profiting from–Black Swan events.
Trying to apply the concepts of barbell investing will force investors to look at their investments from a different perspective, perhaps even prompting them to take action and make their portfolio more “antifragile“.
If the barbell investing strategy doesn’t appeal to you, there are certainly other methods. The CAN SLIM method is more suited to people who like looking at charts, while the Magic Formula is more suited to people who like a very systematic way trading, and don’t mind the odd financial ratio or financial statement.
Disclaimer: This article is for educational purposes only, and the authors and this site don’t necessarily recommend this investing approach. It is just one of the many possible ways to invest. This article should not be viewed as investment advice.
Written by: Jiva Kalan: A researcher and writer whose work is featured on DailyFinance, the Wall Street Survivor and Financial Choice.
Edited by Cory Mitchell, CMT
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