Investors schooled in the Buffett era or the Markowitz Modern Portfolio Theory seemed outdated in the age of disruption.
The investment heroine today is epitomised by Cathie Wood, the lady boss at Ark, who had a handful of ETFs achieving more than 100% in 2020. She believes money is made in the disruptors and not value stocks.
The market has been on the side of the disruptors and more investors are looking at Tesla and the likes after a dizzying run in their share prices. Getting multiple folds from a tech stock has become a commonplace on social media.
Value investors had many tough years and only saw some encouragement at the start of 2021 while the tech stocks took a beating. But not many know how this will play out eventually.
Some value investors may have felt left out in the tech run but at the same time, they feel that it is too hyped up to get in at the moment and not want to be get caught when the disruptor stocks crash.
But what is overvalued can go up even higher and value investors miss out even more. What a dilemma.
I have a solution which I borrowed from Nassim Taleb – the barbell strategy.
I always say that investment is a religion and everyone tends to think his approach or belief about the markets is a correct one.
There are those who believe in value and there are those who believe in disruptors.
The barbell strategy says you don’t need to be so rigid about it.
In fact, it is more beneficial if you do both. Go to the extremes – own the safest and the riskiest stocks at the same time. This is akin to the Taoist concept of yin and yang – these dialectical investments balance out and harmonises.
What is a Barbell Portfolio?
Nassim Taleb wrote about it in his book, Antifragile,
“If you put 90 percent of your funds in boring cash (assuming you are protected from inflation) or something called a “numeraire repository of value,” and 10 percent in very risky, maximally risky, securities, you cannot possibly lose more than 10 percent, while you are exposed to massive upside. Someone with 100 percent in so-called “medium” risk securities has a risk of total ruin from the miscomputation of risks.”
Hence, as the name suggests, a Barbell Portfolio looks like a barbell (yes, the one in the gym, just that it is lopsided):
It is about investing 90% of your capital in safe investments and 10% in high risks ones.
Safe has a specific definition here. It doesn’t mean you have to literally go all cash. It just means there is no chance that the investment will go to $0. A well diversified portfolio with no leverage makes the cut.
The 10% allocation is the exciting part. Fancy Tesla? Buy it. FOMO bitcoins? Buy it. It allows you to participate in many of the high risk investments without guilt because you have already taken care of the risk in the other 90% of the portfolio.
I prepared an example below.
Backtesting a Barbell Portfolio
I used Vanguard Small-Cap Value ETF (VBR) to simulate a typical value investor’s portfolio.
Second, I chose bitcoins and Tesla (TSLA) as the symbols of disruption.
Lastly, I included S&P 500 ETF (SPY) as it is the most preferred ETF among index investors.
With these investment options, I built 3 portfolios (starting with $100,000 each) and backtested it between 2014 and 2021 (limited by the data range):
- Portfolio 1 = 90% in VBR + 5% in bitcoins + 5% in Tesla (Barbell Portfolio)
- Portfolio 2 = 100% in SPY
- Portfolio 3 = 100% in VBR
Below is the performance chart:
Portfolio 1 (Barbell) outperformed the rest with a 28% annual return and the ending balance of $582k.
An index investor in Portfolio 2 (SPY) would have achieved 13% annual return with an ending balance of $236k. It is pretty good returns actually.
Lastly, a value investor with all his money in value small caps (Portfolio 3) would have underperformed with 9% annual return and ending the period with $186k. Actually it isn’t that shabby but I guess wealth is relative and this investor probably felt inadequate even when his wealth has grown nicely. It also goes to show how value has underperformed, lagging SPY by 3.7% annually!
Key points from the results
Before you accused me of cherry picking bitcoins and Tesla, let me clarify a few things.
I chose bitcoins and Tesla because they are popular among the masses and it’s more likely that someone would invest in them. But it could be any other higher risk stocks or investments and even if they don’t work out, it is only limited to 10% of the portfolio. The remainder 90% can still pretty match the index returns.
Barbell allows you to enjoy the tremendous upside when you are right and take little downside risk. That’s the beauty of it.
Second, you would notice Portfolio 1 (barbell) is a lot more volatile than the other two portfolio, measured by the standard deviation and the worst year performance – it was down 34% in one of the years! This is where investor psychology will play a big part. Not many investors can handle such volatility and they may sell a risky asset prematurely. If so, these returns would not be achievable. And not just the downside, but also the upside – some investors may not be able to resist taking a 100% profit on bitcoins or Tesla. They may also missed out the remaining upside when they do so.
Lastly, the Portfolio 1 (Barbell) has a better risk-adjusted returns as show in its higher Sharpe ratio. In laymen terms, it means that a Barbell portfolio is actually safer than a portfolio that is 100% in S&P 500, despite having high risk investments in bitcoins and Tesla. This sounds counterintuitive but that is the key benefit of Barbell as espoused by Taleb – a very safe portfolio with potentially large upsides!
Barbell Portfolio for you
You no longer need to restrain yourself from buying the exciting disruptor stocks. A Barbell Portfolio provides you a portion of capital to take risks responsibly. Value investors can explore carving out 10% of the portfolio to buy stocks that they always wanted but felt risky. It gives you the permission to do so and it is liberating.
You don’t need to participate in the value and growth debate. You can own both with Barbell.
If you need more details how to go about structuring a Barbell Portfolio or what kinds of investment can go into the safe and risky parts at the moment, I run a Barbell Investing Course should you be interested. Here’s a free session to know more about the course.