Are you, during these Covid times, doing something like this – working 10 hours on your routine office work and then spending a refreshing 2 hours with your family in a heightened flurry of activity? Instead of spending intermittent time all through the day and achieving nothing? If yes, then you have already been introduced to a financial concept called the BARBELL strategy without having recognised it!
Introduction to The Barbell
Well, if you aren’t still taking personal time off , maybe you are familiar with an old aunt saying things like “Marry an accountant, but have occasional flings with rock stars” or your gym instructor saying “Lift very heavy weights for a few repetitions, then do lots of low-impact cardio.” All of these refer to the same concept in life called The Barbell!
Essentially, a large exposure of your time or energy on “low risk” activities that keep the system working and a small but adrenalin extreme at the end which results in the outcomes we desire – instead of a continuous boring commitment to everything intermittently.
Barbells in Investing
A barbell is a piece of exercise equipment consisting of a long bar with weights attached at each end. In finance the barbell strategy has been typically associated with a fixed-income portfolio management strategy, in which half the portfolio is made up of long-term bonds and the other half of very short-term bonds.
In finance, a barbell strategy is formed when a trader invests in long- and short-duration bonds, but does not invest in intermediate-duration bonds. This strategy is useful when interest rates are rising; as the short term maturities are rolled over they receive a higher interest rate, raising the value.
The barbell strategy attempts to get the best of both worlds by allowing investors to invest in short-term bonds taking advantage of current rates while also holding long-term bonds that pay high yields. If interest rates rise, the bond investor will have less interest rate risk since the short-term bonds will be rolled over or reinvested into new short-term bonds at the higher rates.
For example, suppose an investor holds a 2-year bond that pays a 1% yield. Market interest rates rise so that current 2-year bonds now yield 3%. The investor allows the existing 2-year bond to mature and uses those proceeds to buy a new issue, 2-year bond paying that returns the 3% yield. Any long-term bonds held in the investor’s portfolio remain untouched until maturity.
As a result, a barbell investment strategy is an active form of portfolio management, as it requires frequent monitoring. Short-term bonds must be continuously rolled over into other short-term instruments as they mature.
The barbell strategy also offers diversification and reduces risk while retaining the potential to obtain higher returns.
Barbells for Equities
The 2008 financial crisis was an example of a “Black Swan” event, a one sided collapse that most people had no inkling of and strategies were not prepared to handle. 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.
A fund manager who shone to ultra stardom that time was Nissim Taleb who argued against this “normality” assumption – he assumed that the likelihood of extreme events (like a 2008 recession) are far more likely and that “Black Swans” are inevitable, unpredictable, and when they occur, your losses will be far greater than you ever imagined.
The barbell strategy utilized by Talen’s fund 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- it went from just over $300 million under management to $2 billion in assets in the very first year of operation!
Nassim Taleb in his book “Antifragile“, recommends to clip the black swan downside by being extremely paranoid to risk and expose to the upside by being extremely risk loving. An example he gives, to limit the downside by having 90% or so in secure investments and the remaining 10% in risky bets. Taleb presents the barbell strategy as a bimodal attitude of exposing oneself to extreme outcomes: one extremely risk averse and another very risk loving, while ignoring the middle. The objective of the strategy is to limit downside and to get exposure to extreme upside outcomes. The possible outcomes are more certain, and the risk of exposure to “black swan” events is much smaller.
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.
Another Proponent – Ray Dalio
Ray Dalio , another famous money manager, has modified and popularised this strategy to investors by varying the 90/10 rule while maintaining essentially the same principles. The core insistence of the model is to avoid the mushy middle of moderation. Be very conservative AND very aggressive. E.g. “conservative” cash & risky stocks- middling stocks add no value but take all the risk of markets. Extremely risky assets are usually known to be extremely risky so they are priced by the market with the expectation of loss of principal as a real possibility- Because risk is very much top of mind when investors consider extremely risky assets, these do offer compensation for the true risk the owner runs. Remember that a 20% drop in a position that makes up 1/20th of the barbell isn’t going to affect your health, happiness or fortune very much- Even though they may exhibit volatility.
Being in the middle gives the illusion of safety, but it’s actually the worst of both worlds: you’re still vulnerable to being wiped out by a black swan, while also having no opportunity to tap into the stratospheric gains that swirl out of the same chaos.
It’s not the specific weights that are important, but the general principles:
- decide on an acceptable level of downside risk – which will vary from person to person,
- make room for as much upside potential as your personal circumstances allow, and
- stay the away from the middle.
Individual investors could utilize a similar approach, investing a large chunk of their portfolio in low risk investments like FMCG and Pharma, a portion in high beta stocks like high PE NBFCs for instance, 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.
Final Word on Barbell Investing
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.