Every investor wants maximum returns on their investments while taking minimum risk. Higher the risk, greater can be the returns. But is it possible to achieve maximum possible returns for the given risk or limiting risk to tolerable limit
Barbell strategy is an investment concept that suggests that best way to strike balance between reward and risk is to invest in the two extremes of high risk and no risk assets while avoiding middle of the road choices
Decades of empirical research has demonstrated that it is very difficult to beat passive investment approach or market returns. But still people tend to believe that they can control positive investment outcomes - when in reality luck, chance or randomness is what mainly drives investment results. Investing success is also about luck as much it is about skill. Very few fund managers can show track record of consistently beating Index or market as a whole for extended period
The Market Always Wins
The roulette wheel has long been a fixture of casinos all over the world. In the more unfair American version of the game, there are 18 red slots, 18 black ones, and 2 neutral ones (the European version only has 1 neutral slot). So the probability of getting red or black on any given throw is 18/38 (or 47.37%). And the probability of not getting red or black on the same throw is 20/38 (or 52.63%). The tiny difference of 5.26% in the probabilities gives the casino a significant advantage over a large number of spins of the wheel. In other words, the house always wins in the long run.
Fortunately for investors, there is no need to own a casino to have the same winning advantage; the stock market can offer the same benefit because of a long-term "upward bias." Let us take a look at the Dow Jones Industrial Average index. Over the 100-year period, there were more than 26,800 trading days. About 53% of the time the market closed in positive territory - nearly identical to the casino's winning percentage in a roulette game.
However, this winning advantage only becomes evident over a long period of time. Over shorter time periods, the market can appear very irrational and unpredictable - a bit like tossing a coin or rolling dice. Those who attempt to time the market could, by chance alone, be proven right on a good few occasions, thereby reinforcing their false sense of optimism about the effectiveness of their strategy. But in the long term, market timing is more like playing with a roulette wheel where the market is the casino with a tiny winning advantage, which clearly explains why passive investing mostly beats active investing.
In order to take advantage of the long term upward trend of the market, investors can construct a safe, widely diversified portfolio and trade very infrequently. This reduces risk to very insignificant levels while giving positive returns near to market levels in the long term.
For eg. Buying ETF or Index with very low expense ratio
What is Barbell Investing?
This passive investment approach will work very well in long time frames. Giving good returns with very less risk. But, it does have one major flaw - it offers no protection against negative “Black Swan” events. Such black swan events cause unexpected or major market downturn or crashes, events like 2011 terrorist attack, 2008 financial crisis, 2010 flash crash, and 2020 Covid crisis. Therefore, the optimal investment strategy must be the one that takes advantage of the passive investment approach, while at the same time hedging against market crashes. Best way to accomplish this is to employ something called a “barbell” asset allocation strategy.
Based on investors profile his risk tolerating capacity should be identified. For example, a young investor will be ready to take plenty of risk while a retiree may want less volatility in his portfolio.
Barbell strategy divides portfolio into two different types of assets. One basket holds extremely safe investments while other holds speculative or highly leveraged instruments
Safe assets
Blue chip stocks
Buying Index ETF
Gold and other commodities
Corporate bonds
Government bonds
Short term and Long term bonds
Commercial papers
NCDs
Certificate of Deposits
Bank Fixed deposits etc.
Risky Assets
Microchip and small-cap stocks
IPO’s
Cryptocurrencies
Portfolio Hedges
In Barbell strategy the middle of the risk spectrum is ignored. This strategy advocates pairing two distinctly different types of assets. One basket holds only extremely safe investments while other holds only highly leveraged and speculative investments
This approach famously allowed Nassim Nicholas Taleb, a statistician, essayist, derivative trader and risk analyst to thrive during 2007-2008 economic downturn while many of his fellow wall streeters floundered
He was a pioneer of tail risk hedging (now sometimes called "black swan protection"), which is intended to mitigate investors' exposure to extreme market moves. His business model has been to safeguard investors against crises while reaping rewards from rare events, and thus his investment management career has included several jackpots followed by lengthy dry spells
What is black swan event?
The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The term is based on an ancient saying that presumed black swans did not exist – a saying that became reinterpreted to teach a different lesson after the first European encounter with them
Taleb described the barbell strategy’s underlying principle this way: "If you know that you are vulnerable to prediction errors, and accept that most risk measures are flawed, then your strategy is to be as hyper-conservative and hyper-aggressive as you can be, instead of being mildly aggressive or conservative."
Applying Barbell Concept
Barbell strategy involves investing 90-99% of one's assets in extremely safe instruments with the remaining 1-10% being used to make diversified, speculative bets that have massive payoff potential.
In other words, the strategy caps maximum loss at 10%, while still providing exposure to huge upside. This amount can be deployed in 8-10 very high risky investments like crypto or micro/small cap stocks.
If any of our risky investments going to zero hits you with only 1.5-2% of your investment
10x return on any of these is meaningful for your overall portfolio
For core portfolio you can allocate no more than 75% in equity and no less than 25% equity at any time. Equity allocation = 100 - Age
One of the approaches used by some of the investment firms is to allocate 98-99% of the money in an ETF that tracks Index funds and use the rest of the 1-2% for a dynamic hedging strategy which will give profits in market crashes. Like buying put options on their investments or index which can give multi fold returns when the market goes down. Gains achieved by hedging are reinvested back into Fund or ETF which gives additional advantage of investing in equity when market valuation is down
Goal of two ends of the barbells can be to generate greater alpha and prevent drawdowns. One end like hedging can help mitigate exposure to negative black swan events while other end can help preserving exposure to positive black swan events (e.g. rise in crypto or some futuristic microchip company)
Conclusion
Market can seem random or highly unpredictable in the short term because there are a large number of factors on which stock prices depend. There are lakhs of investors bidding for price at any point of time based on global factors, economic conditions, domestic news, company results etc. It is difficult to predict the behavior of investors considering all these factors. But over a long time period, investors have a small winning advantage and the market will go up (just like roulette wheel, where the casino always wins). For most investors doing passive investing or investing in safe stocks will suffice for achieving greater returns.
More sophisticated investors can take a step further and employ a barbell strategy to combine safe investment with dynamic hedging to protect against black swan events