Monday, June 9th, 2008...9:20 am
My Take on the Barbell Investment Strategy
In the post Meet Nassim Nicholas Taleb, I dropped in this quote without adding any comments.
…the good investment strategy is to put 90% of your money in the safest possible government securities and the remaining 10% in a large number of high-risk ventures. This insulates you from bad black swans and exposes you to the possibility of good ones. Your smallest investment could go “convex” – explode – and make you rich.
Do I support this investment strategy? My short answer is it depends. Taleb has two variables isolated in this quote.
- Percentage of money allocated to the safest investment. (90%)
- Percentage of money allocated to high-risk ventures. (10%)
Let me add my own personal 3rd variable:
Are we in a secular bear or bull market?
Once you determine if the current investing environment resembles a secular bull or bear market, then you can adjust your definition of safest. If the conditions indicate a bull market is more likely then having 90% of your investment tied up in low yielding government debt seems foolish. If the market is range-bound or in a secular bear market then the goal is preservation of capital not appreciation of capital. As I explained in my post Mr. Financial Planner - Go Home and Get Your Shine Box! there is nothing wrong with near-cash investments in this market environment.
What makes Taleb interesting today is many investors now see the secular bull market from 1982-2000 is not coming back anytime soon. The mantra of Investing in Stocks For the Long Term is historically a fools move in a range-bound or secular bear market. But we still want the possibility of making a lot of money while preserving most of our capital. Hence the barbell strategy.
Taleb has spent the last twenty years on Wall Street so he has amble time to think about how to deploy his 10% on high risk ventures, while having the piece of mind knowing that 90% of portfolio is safe. Most investors will be ill-equipped to measure the risk versus reward to exploit those opportunities.
Learning how to spot under-valued investment opportunities that although risky provide a huge potential payout is something I’m interested in exploring. That statement is not an invitation to promote your business in the comments below. I’m more interested in discovery methods than the actual discovery.
5 Comments
June 9th, 2008 at 1:28 pm
Briefly, I’m an ‘old school’ investor who likes to keep it simple: (a) “there are no risky investments, only risky investors” and (b) “invest only with insider information”. “Insider information” here doesn’t mean illegal information. It means know the ins and outs of an investment: the ‘inside” being the financials of the investment and the management team behind the investment; the ‘outside’ meaning the market FOR THAT SPECIFIC INVESTMENT.
The first part above — “only risky investors” get to the “stick with what you know”. For example, if you know a lot about vaccuum cleaners, like the financials of the company and like the management team of a certain company that manufacturers vaccuum cleaners invest in that vaccuum cleaner company and go ‘all in’ (i.e. put a lot of your capital there). I also want to have a lot of control over my investment (probably over 75% of my liquid capital is in investments that meet the above criteria): (1) something I know, (2) something I have insider information about, and (3) something I directly have major control over. The rest of the 10% can go into very passive stuff like money markets, mutual funds, Roth, etc.
Finally, I believe there is a risk spectrum generally and also within an asset type and within asset subtypes. For example, for me, I’m a real estate guy, so 90% of my money is in real estate but cash flowing retail and apartment real estate (passes the first three tests — I know it, have insider information, and control the investment). But, real estate DEVELOPMENT is a risky investment for me. So, I may have 80% of my 90% in real estate but in retail and apartments cash flowing real estate and the remaining 10% in ‘forced appreciation’ deals such as development …
Matt
June 11th, 2008 at 9:38 pm
I know some people who are very good at what they do (i.e. say biotech or software) that might be very successful at this, but most of us are competing directly with MANY analysts on Wall Street who have access to way more info than we do …and do this as a day job.
The idea that Joe-6-Pack is gonna pick a 1000-bagger with 1% of his portfolio seems ludicrous …yet that would only increase portfolio size 10 times …maybe over 20 years.
On the other hand why would you want to tie up 90% of your capital on bonds in a Bull market?? If you threw 10 darts at the WSJ in 2002 and invested 10% in each company …then sold in 2007, you probably would have doubled your money!
The key …in my humble opinion …is to be fully invested in equities in Bull markets …and in some combination of short equties, cash or bonds in Bear/Sideways markets (depending on how well you want to sleep at night).
June 11th, 2008 at 10:05 pm
Final note …there are ways to determine bear versus bull that I’ve posted previously. The two most common:
- Buy/sell equities when the 200DMA crosses the 50DMA +/- 1%.
- Buy equities when PEs go below 10 and sell equities when they go above 20 or so.
By the way …if you shorted the S&P at the 50/200 “death cross” you would have made 10% to date and would never have gone under water. Double shorts of course would have generated 20% since November.
June 12th, 2008 at 4:59 am
Maybe a single post wasn’t enough to fully explore the barbell strategy. A key point Taleb hits on is the concept of undervalued unexpected outcomes. The keyword being undervalued. By exposing a small percentage of our investment to the possibility of a positive Black Swan, while protecting the bulk of our money from a negative Black Swan - we can come better.
In one of his two books, he goes into detail on how human biology sets us up to undervalue situations which can make us rich or break us.
June 12th, 2008 at 5:06 am
Jim - I agree with your rules on how to leverage the “safe” portion of your portfolio. I did a post on the 50/200 rule here:
Simplest Investing Rule
I think my goal will be to use simple rules and history to manage 90-95% of my investments and then seek out undervalued unexpected opportunities with higher payoffs for that last 5-10%.
In 2006, John Paulson made a billion dollars when he learned how to short subprime debt. In retrospect it was so obvious, but it was an outcome with a huge payoff that very few people were exploring.
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