I’ve been investing in the markets for over 16 years, 5 of those as a professional trader. I came out of college in the middle of the dot-com bust and was lucky to get my first job as a banker. I traded through the financial crisis and Great Recession, and I’m now trying to navigate through this pandemic induced depression-esque market. Like many of you, I’m struggling with what to do.
Since my trading days, I’ve become much better at not losing money, and I want to share a little of how I do that by employing a barbell investing strategy. To some, this may seem ultra-conservative, but I believe it actually takes out a great deal of risk and allows me to be very aggressive when the time is right.
What the heck is a barbell strategy?
The vast majority of financial advisors will talk to you about asset allocation that roughly mimics a normal bell curve like the one below. This strategy calls for setting aside enough cash to weather a storm, spreading your money out amongst asset classes (typically 60/40 stocks to bonds), and maybe a small allocation to very high risk asset classes, and some cash. If you were to graph this with risk on the X axis it might look something like this:
A barbell strategy on the other hand basically involves investing on the ends of the risk curve and avoiding the middle, and looks something like the below graphic. What this means is that I keep a lot of cash on hand, very little stocks, bonds and traditional market assets, and then allocate a much smaller percentage of my liquid assets to alternative investments with a higher risk profile such as high yield bond speculation, derivatives, private equity, venture capital and cryptocurrency.
A barbell strategy can easily be applied within asset classes as well, say, holding 80% blue chip dividend stocks with great balance sheets and 20% small cap growth stocks. Or, the same allocation of treasuries to junk bonds in a bond portfolio.
Why avoid the middle?
One of my favorite thought leaders on the subject of risk is Nassim Taleb, who authored Fooled By Randomness, The Black Swan, and Antifragile. Taleb is a mathematician, risk expert and former hedge fund manager, who rose to prominence during the financial crisis of 2008 because he predicted it. Taleb argues for a barbell investing strategy because he believes over-engineering of the global financial markets, leverage and how interconnected all the banks are makes the system less robust and more fragile. Thus, smaller shocks to the system get exacerbated more frequently. These risks are essentially “hidden”. there are hidden risks in the middle (stocks and bonds) that do not get accounted for in modern financial risk models.
Mortgage Backed Securities Risk
A great example is how every single one of the major US housing default models used to package Mortgage Backed Securities, did not include the ability for home prices to go even the slightest bit negative. When home prices went the slightest bit negative, the entire thinly capitalized mortgage system seized up and cascaded to every interconnected financial market. This was a major risk that was not accounted for by a simple tweak to a model.
Basically, a historically safe asset class (homes) was transformed into a very risky weapon of mass destruction via financial engineering.
Stock Buyback Risk
Another example that we are seeing play out now is corporate stock buybacks. Low interest rates have incentivized CEO of companies to issue debt to buy back shares to boost stock prices. While this behavior has increased stock prices in the short term, corporations are left without the free cash needed to weather rough times such as the global shutdown of business due to the COVID 19 pandemic.
Many of these companies have been buying their own shares right into the highs, and now suspending buybacks when prices are low. This obviously violates rule number one of investing – buy low and sell high.
What’s important to understand for this article, is that issuing cheap debt to buy back shares has dramatically altered the risk profile of stocks (hidden risk) to the point that thousands of public companies might cease to exist without federal bailout assistance.
How I use a barbell strategy
The purpose of a barbell strategy is to avoid hidden risks and take more control over investment strategy by staying very safe (cash) and taking high risks that are understandable with a smaller portion of the portfolio. Theoretically, you can achieve a decent blended return and limit your exposure to black swan type events.
#1. “Cash is king”, not “cash is trash”
Ray Dalio, the billionaire hedge fund manager (who I actually respect and admire) proclaimed “cash is trash” in a CNBC video, advocating for a global stock and bond portfolio. That interview pretty much marked the top of the bull market as global stock markets have melted down. He has a good point that I won’t go into here, but for the average person (i.e. not a billionaire hedge fund founder) cash is actually king.
Yes, interest rates are terrible for cash savers. However, cash is a low cost form of insurance against everyday setbacks. Paying for a $400 emergency with cash instead of getting a personal loan or worse, has value.
But let’s talk about investing. Cash has options value. In finance, an options contract has an implicit value because it is a right, not an obligation. You have the option to do A or to do B. Having a good cushion of cash sitting in the bank allows you many options to invest when the time and opportunity are right without selling other assets (stocks, your home) to free up the cash.
The flexibility that comes with this option value is a key piece of information missed by most people. I have close to 80% of my liquid assets in cash. So, I was able to avoid the recent stock market downturn, and now I can pounce on good investing opportunities at great prices.
By the way, do you know how much cash on hand Buffett’s Birkshire Hathaway keeps on its books?
Many people think insurance is a waste of money, but as Talib points out in his book, Antifragile, insurance is an asset that will actually perform better for you in volatile times. Insurance is essential and has a high payoff for you at the precise time risk increases. Having adequate amounts of homeowners insurance, car insurance, umbrella coverage, and life insurance are key to avoiding adverse situations where you have to spend a huge sum of money unexpectedly.
I also use key man insurance in my businesses along with general and professional liability coverage.
#3. Low exposure to stocks and bonds
Contrary to the advice of most money management professionals, I keep very little relative exposure to traditional stocks and bonds. I have retirement accounts that contain these instruments that are passive.
If you look at my actual liquid asset allocation vs what a top fintech money manager says I should target, you can see how their advice (green bars) is the exact opposite of my strategy.
My exposure to stocks and bonds are in the form of low cost ETFs in my tax advantaged retirement accounts. Because my duration is long on this money (meaning I won’t need it for 30+ years) I am ok with the exposure, and I believe the tax compounding over time makes up for the additional risks.
#4. 10-15% exposure to pure-play risk
A pure play risk is generally an investment that carries a high expectation of failure, but a massive payoff if it works. The best example is a startup/venture capital type investment. The best estimates are that 75-80% of new businesses will fail – that’s the base case. But the expected return on an investment that does well is not 6% per year. It’s more like 4-100 TIMES your investment.
Because the risk is so high in these investments, there generally aren’t a lot of hidden risks – I basically have a good idea of my expected loss going in. I don’t believe that is the case for most generally accepted financial investments as the last several financial crises have shown us.
So what does this look like? I seek out pure play exposures that are not tied to the stock market. I invest in startups and back local entrepreneurs like restaurants. I also maintain a decent size cryptocurrency position that I began accumulating in 2014. I plan to hold this investment until crypto is a proven winner, or ‘goes to 0’ because the magnitude of the payoff is enormous if the bitcoin experiment works.
#5. The remaining 5-10% I invest in myself
I use this money to increase my skills, and leverage what I am good at to make me and my companies more marketable. This process has compounded my earning power over time and allowed me to re-invest in my businesses, or in other non-correlated passive income sources.
Is a barbell strategy for you?
A barbell strategy’s main purpose for an astute risk manager is to remove the probability of large blowup events from seemingly ‘safe’ investments. A barbell isn’t for everyone, but one of the main benefits I’ve seen from it is psychological – I know with certainty, that no single event will impact my family’s financial security. That allows me to take more risks with a smaller amount of capital and be better connected to the companies, opportunities, and people that I invest in.
What are your thoughts? Are you worried about risk, and could a barbell strategy help?