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building a barbell portfolio

Building a “Barbell” Portfolio

I hadn’t thought of my barbell portfolio page in a while when Tim, a friend of mine emailed me recently. Here’s what he wrote:

I am listening to Nassim Nicholas Taleb’s new book Antifragile, and he discusses the barbell investment strategy at some length.  I googled it and Walnut Hill came up about number four on the search.  Were you channeling him, was he channeling you, or were you both channeling some third and wiser party?

Of course I laughed. But I was also a bit surprised. I have one page on my site which outlines what a barbell portfolio is. So getting a #4 google ranking is quite interesting to say the least. Nonetheless, Tim’s email motivated me to follow up on that page! Because that style of investing likely appeals to many people. With that said, in this article I want to:

  1. Lay out the current realities of barbell investing in today’s zero interest rate environment.
  2. suggest ways to adjust the theory in light of said zero interest rate policy.
  3. suggest portfolio components that may fit this current “adjusted” view of differences between risk vs risk-free assets.

Barbell Portfolio = Simple

Before we get started, please review my page on Barbell Investing so that you are up to speed on what we’re talking about. But in summary. Barbell Investing is:

…a very simple investment allocation where your assets are focused on the extreme ends on the risk spectrum. Just like with a barbell, the weight is on the two ends. In other words, if the two ends of the barbell represent opposite ends of the risk spectrum, then you would allocate all of your money between the very safe end and the very aggressive end. For example, you might allocate 80% of your money to inflation-protected treasury securities (TIPS) and 20% of your money to very aggressive small growth company stocks.

Note: when I discuss risk with barbell investing, classically I am discussing principal risk only, not inflation risk, etc.

Realities of a Barbell Portfolio Investing

I must say upfront, that barbell investing is much easier when bond returns/interest rates are higher. For example, if your goal return is 8%/year, and you can earn 6% in a bond. It is much easier to get that average up to 8% with the stock portion of your portfolio than it would be with bonds earning 3%. But dreaming doesn’t help us. So what do we do?

Here are some choices you could consider:

1. lower your expected return. Yes this is not the option you want to hear. Here is why some people argue it. Some theories suggest that your portfolio expected return should be some function of what the “risk-free” rate is. Example: if you can get 6% in a bank CD, then your expected return on a risky asset like a stock could be 12%. But if you can only get 2% on a CD, then your expected stock return should be 8%. Understand? So if you can buy into that theory, your solution may be to lower your return expectations.

2. Change your view of risk. To most people, risk-free means a CD or a savings bond. But in this world of zero interest rate policy (ZIRP) by the Federal Reserve, and with Ben Bernanke’s intended goal of driving you out of “safe” CDs (because the rates of return are simply unacceptably low) and into risky assets (yes a Fed chairman actually said his goal was to prop up the stock market), we have to think differently. It could mean something as adventurous as calling a dividend paying stock of a stable, relatively inflation-proof company a “safe” investment!

3. Look outside the US and developed world to expand your selection. Perhaps there is a stable country with bonds paying a better interest rate. Perhaps there is a stronger currency for your parked money. Perhaps there are places where raw growth is better than in the US, Europe or Japan.

Constructing a Barbell Portfolio with Updated Thinking

In the old days (maybe 10 years ago), one could buy a government bond at a decent yield (4-5%) and simply buy call options on stock exchanges and get 75% of the potential return of the markets with ~90% less exposure to risk of principal loss. now, with unlimited money printing by central banks, we have to consider more the risk of monetary inflation on assets. If inflation were truly a great risk, it would reduce the focus on principal risk as we’d be more concerned about our money becoming worthless, even if we don’t lose any!

Here a a few portfolio ideas, in no order of effectiveness, risk nor preference. These are hypothetical ideas of portfolios and the actual investments chosen should be put together by a financial professional who understands the risk/reward, correlation aspects, and determinants of performance of each of these investments (FYI: this was my version of the ‘seek professional advice’ disclosure!).

Example 1

Therefore, a complex “updated” barbell portfolio might include 80% exposure to a balanced/conservative portfolio with managed income investments like dividend stocks, preferred stocks, market neutral strategies, merge-arb strategies, and managed global bonds. The other 20% would be in “risky” assets such as options, aggressive growth portfolios exposed to global small company stocks, discovery investments – where there is more of a binomial result (big bang or big blow up!), and aggressive inflation protectors such as gold stocks for smaller investors and/or way out of the money calls/puts on currencies or bonds for more sophisticated investors.

Building a barbell portfolio
Image Courtesy of Adrian Clark

This portfolio would have a higher expected return in my opinion though the principle risk could be higher than desired for a typical barbell investor. This portfolio would likely have good inflation protection built in despite the higher principal risk.

Example 2

A simpler barbell portfolio could include a portfolio consisting of ~+/-90% in global government bonds with ~+/-10% allocated to call options on global stock indices. Though some may consider global government bonds not as safe as US government bonds, remember our discussion above about the current times. Also, there are quite a few people, including “The Bond King” Bill Gross, who would agree with him that US government bonds will be “road kill.”

This portfolio could come close to the old US version of earnings a nominal 4-6% yield on the bonds and a potential overall return close enough to the fully invested potential return to make you happy. The diversified currency aspect of a global portfolio reduces currency/inflation risk of the home currency tremendously. The problem is that the ‘textbook’ answer would still say this portfolio is more risky than a US-based portfolio (government, currency, legal, trade risks etc). Think of that as you will.

Example 3

A third example I will give but it may be late on all of these ideas. Because of “ZIRP” over the last 3 years, professional money managers have

Photo Courtesy of 401(k) 2012
Photo Courtesy of 401(k) 2012

scoured the country looking for safer higher yields. Therefore, an oddball barbell portfolio I would have had you consider 3 years ago – tax lien investing, depressed real estate, mortgage notes (all real estate related and all producing major 3 year returns) – would not work now most likely. However, in some areas of the country, perhaps directly owned rental real estate could be the conservative portion of the barbell. In other words, the down payment. With the “risky” portion in any of the securities ideas mentioned above.

This idea would have some inflation protection built into it (house is a real asset, not a financial asset), some yield (just ask Warren Buffet, Goldman Sachs and many others earning 7+% yield on their real estate portfolios), and some downside principal protection (houses won’t likely go to zero!). Risks are liquidity (there may come a time again when houses are difficult to sell for anything more than a bargain price), real estate-related costs like taxes, upkeep, insurance, and certainly market risk to some degree as by nature, borrowing money means it’s a leveraged asset.

Bonus Ideas

2 other ways to potentially reduce risk on the safe side of the barbell could be to consider:

Summary

All of these ideas are not recommendations. This list isn’t exhaustive of the possible ideas. Heck I may or may not like these portfolios myself. But they could appeal to certain types of people. And it offers an alternative to simply buying a bunch of risky assets and hoping they don’t crash.

 

Right now, your current financial advisors might be kissing your butt to keep your business rather than telling you the truth and holding you accountable to get the job done. Your life will be much better when someone is holding your advisers and you accountable. Are you willing to be accountable to  actually implement all the things you need to be done to actualize the things on your financial roadmap?

Do you like the idea of a clear visual of the planning process and a simple overview of your Financial Roadmap?

If you found yourself nodding a bit, and get the idea of why you want to have a high level team of advisors, accountable to you, working in a coordinated way, helping to make sure you achieve your goals, lets continue the conversation.

Plan with Chris 

Feature image courtesy of Debra Roby