What is barbell investing?
Barbell investing is a strategy that was first utilised by bond traders, but through several proponents, has found its way into the stock market too. For me personally, Nassim Taleb has held the greatest sway over me in this area, so I dedicate this article to him.
To first understand this strategy, visualise a barbell. There is one plate on one side, and another on the other. There is absolutely nothing in between. This metaphorical barbell represents the risk paradigm in investing, on one side extreme conservatism and on the other extreme risk. In the case of bonds, there was a mix of short term bonds (1> year durations) and long term bonds (10< year durations). 90% of the portfolio would be in the former, and 10% in the later. There is absolutely nothing in between here.
Importantly, the high risk bets are highly diversified and offer asymmetric returns. In the 10% portion of the portfolio, there could easily be 30 different positions, ensuring that one single position can’t wipe out the entire portfolio. However, a single position can return enough to more than compensate for any of the losses you incurred.
Think about it, imagine if you somehow got invested in Amazon when it was worth $50 million, and at the same time you made 9 other investments with the 10% portion (I chose this number for the sake of simplicity). Well, those other 9 bombed, but your Amazon investment is up roughly 35 000 times. No, that isn’t a typo. Now, the chances of you pulling this off, is incredibly small, but there are a plethora of other investments that can return even just 1/100 of this without risking an outlandish sum of money. Yes, there will be complete wipeouts in the portfolio, but by being willing to accept this risk you leave yourself open to opportunities such as an Amazon-esque investment. This is something a portfolio steeped in the middle ground could never achieve.
Apart from leaving yourself open to massive, asymmetric returns, your portfolio risk is actually reduced too. Now, this may seem counter-intuitive, as you are investing in highly speculative positions, but you are also likely forgetting about the other 90% of the portfolio. In most cases, this will be held in short term government bonds or just cash. This is the anchor and ensures that the most your portfolio can lose is 10%.
Picture this portion of your portfolio as the ‘gunpowder’, and it has to be kept dry until the optimal time. Only when an optimal situation presents itself should this capital be deployed. Think about last year's market crash, and how if only you had the cash, you could have made a fortune. With this strategy, you would have had this chance.
While picking the time of deployment is more of an artform, logically you should average down rather than invest everything at once. You can choose to invest this money in everything, but I believe this is the time to choose the middle of the risk paradigm. Buying a basket of common stock that you have researched is likely to produce the best returns. Once the money is invested, I believe that the stock shouldn’t be held for too long, with a maximum of 5 years. Once you have sold, the process begins again.
While this strategy seems fairly simple, an incredible amount of self discipline is required. To be able to wait and hold cash, especially in a bubble situation, takes courage and patience. To be able to buy when the market is falling takes courage and conviction. Simply put, those of a fickle disposition are likely to find failure, not profit using the barbell strategy.
Two potential strategies:
It would be rude to leave you without an idea for using this, so in the spirit of over achieving I will leave you with two. The first will be simple, and the second will be slightly more complex and inspired from the Universa hedge fund (look it up, trust me).
My first suggestion is fairly similar to what I have already said. The 10% portion should be placed into positions that benefit from positive Black Swan events, such as exploratory mining companies, small tech stocks or just anything that has the potential to increase exponentially. This isn’t the casino, so still research the stocks and pick the best ones inside your circle of competence. With the other 90%, have them in cash or short term government bonds (need the liquidity more than the returns). An interest payment from these then go into far out of the money options with an asymmetric return. This step can be simply left out if you don’t understand options.
When there is a market downturn, the liquidity becomes of paramount importance and the averaging down strategy is implemented. This is likely one of the simplest barbell strategies, nevertheless the same emotional control is needed to produce the best results.
The second strategy is what I call the ‘Bear Barbell’ (BB). As the name states, it focuses on capitalising on market falls. The beauty of this strategy is that in times when cash is needed, the speculative positions produce returns which equals liquidity. The speculative positions focus on far out of the money puts which produce incredible returns when the market crashes. A lot of complex math goes into why these options are cheap, but the main reason is the model that values options doesn’t recognise the true possibility of crashes like the GFC and the COVID crash. For a change, the conservative portion of this portfolio will be in blue chip dividend stock. The dividends will fund the 10% part of the portfolio, as remember, most of them will expire worthless. I am going to restate this, look into the Universa fund to further understand this counter-intuitive approach. The fluctuations of the stock won’t be a concern as long as they are of good quality and have a history of stable dividends (yes, I am aware there is a slight philosophical contradiction here, but it really is one of the best indicators for dividends).
When a market crash happens like it always does, you must not sell your dividend shares, instead the liquidity will come from the options that should have immense returns in these situations. This cash will be reinvested into dividend stocks that are likely at bargain prices, and thus the cycle continues.
There is far more complexity in this strategy, with the combination of stock picking and options, but there are also many variations of this BB strategy that can be made that frankly, I don’t understand well enough to talk about. If done properly, this can be an incredibly lucrative strategy that again, requires an immense amount of mental courage.
While these two strategies are far from the only profitable investing strategies, they are some that I believe capitalise on human herd mentality and reward you for it.
Let me know what you think in the comments!
Disclaimer:
I am not a financial advisor, and this is not financial advice, simply my opinion. I cannot be held liable for any losses you incur if you decide to follow this article's suggestions.