If you are reading this blog, you already know who Nassim Nicholas Taleb is. In his book The Black Swan, he proposed the idea of the “barbell portfolio” as a way to manage risk in investment strategies. The concept draws inspiration from the structure of a barbell, where most of the weight is concentrated at the two ends with an empty space in the middle.
[Real-life barbells have weights evenly distributed between the two sides, at least most of the time. When dealing with financial barbells, one side is often heavier than the other side. Anyway, I hope you get the limits of the metafor]
In the context of investing, the “barbell portfolio” strategy involves dividing your investments into two distinct categories:
Extremely safe assets: These are investments that are highly resilient to market volatility and economic downturns. They typically include cash, short-term government bonds, or other low-risk instruments. The purpose of allocating a significant portion of your portfolio to these safe assets is to provide stability and preserve capital, especially during times of market stress.
Highly speculative, high-risk assets: On the other end of the spectrum, the barbell strategy involves allocating a smaller portion of your portfolio to high-risk, high-reward investments. These might include individual stocks, speculative ventures, or alternative assets such as cryptocurrencies or venture capital investments. The aim here is to potentially achieve outsized returns, capitalizing on opportunities for significant growth.
Taleb emphasizes the importance of avoiding investments with moderate risk, which he refers to as the “fragile middle.” These assets may not provide significant upside potential while still exposing investors to substantial downside risk. He is basically talking about stocks and bonds. The issue with bonds, especially if you are familiar with Taleb’s convictions, it is easy to understand: limited upside from coupons and unlimited downside via default risk. For stocks, issues can be described in various ways but they all reflect the same above idea: 8% average return with 17% volatility, negative skewness, frequent drawdowns > 20%, etc…
By concentrating investments in the safest and most speculative ends of the spectrum, investors aim to achieve robustness in their portfolio, ensuring resilience to adverse market conditions. The concept of a 85/15 split is easy to understand: if the high-risk assets go to 0, the max the investor can lose is 15%. Even when presented with impossible-to-foresee scenarios, this maximum loss makes for a very resilient portfolio. On the other side the speculative 15%, think of it as a bunch of lottery tickets with positive expected returns, can (should?) generate enough gains to lift the overall portfolio results to reasonable levels.
Overall, the barbell portfolio strategy advocates for a deliberate and asymmetric allocation of assets, with a focus on preserving capital and maximizing potential returns through a combination of safety and speculation.
Great on paper, almost impossible in reality.
So much so that not even Taleb himself invests in such a portfolio. At least, that’s not how the hedge fund he launched and the one he advises invest. They were/are designed to be COMPLEMENTS to the fragile middle, not stand-alone investments. And if you have in mind the stellar performance so many discussed last year, here is a great explanation of how it was calculated. Even if Universa is a positive EV fund (a big if, considering its result are not public), that does not mean “you can try this at home”.
Let’s see more in detail the issues of the concept.
The Safety Portfolio
It is easy to build a portfolio resilient to market volatility and economic downturn. It is way harder to have such a portfolio to protect against inflation. Short-term Govies did not do the job everywhere in the World:
What if you live in the next Austria or Japan? That’s the risk if your portfolio is too concentrated. And if you want to diversify, you have to deal with FX risk (hedging that risk is not the solution and if you do not know why…read the rest of the blog ;)).
Maybe a sprinkle of diversification can be the solution? Before 2020, something like the Permanent Portfolio would have done it. But then it lost 20% in a single year…which is probably the best example of the risks Taleb is talking about:
If we then look outside the US, the picture gets even more grim:
Even something like 70% cash, 10% of stocks, bonds and gold would lose money (in real terms) every 5 years:
Sometimes ‘safe strategies’ are the stupidest choice because you get the risks without the returns. As I said, this is Taleb’s point but it is also the rationale behind why his idea cannot be built in the real world. To a certain degree, it is impossible to remove the left tail (even without considering scenarios that involve canned food and bullets).
It is the same reason, despite with a higher hurdle rate, why Stay Rich portfolios are not easy to design. Even when they are built with the best intentions, research and resources, they might still fail.
Broadening the barbell concept, the best Safety Portfolio might be a government job (i.e. something with zero layoff risk), a State pension or an annuity. Unfortunately, while your nominal cash flow might be safe, the real side of it is normally not. And you still have a residual counterparty risk.
The High-Risk Portfolio
Ten-baggers stocks are rare but not black-swan-ish. The real unicorn is the investor who can stick with the stock for the whole journey. It is the same issue as buying options: what to buy is as relevant as when to sell. Ain’t as obvious as it is after the fact.
The risk of buying risk just for the sake of it, instead of buying risk that is going to convert into a return, is high. Not all the risks are compensated. That’s why the High-Risk Portfolio is easier said than done. You need a portfolio that is diversified enough to increase the probability of success but concentrated enough to convert into a meaningful return.
Every investment that turned out to be a life-changing bet was a stupid idea at inception. And there are plenty of stupid ideas you never heard of simply because of survivorship bias. To separate the wheat from the chaff you need knowledge and, more often than not, that type of expertise does not transfer well to another field. The other day I was listening to Josh Wolfe, a master “lottery tickets hunter”, and it is quite revealing how hard is to simply position yourself to be in the right field.
The barbell portfolio concept is intriguing, until you realise how hard is to properly execute it. This does not mean that the concept is useless: as with anything else investing-related, there has to be a trade-off, otherwise everyone would be doing it (sorry, except the dividend stans, obviously).
Bonus Point: The All-Weather
Last week Monevator linekd this post from Roger Nusbaum on the costs, in terms of performance, of using an All-Weather portfolio when the line goes up. I really like Roger’s blog and looking at those numbers is quite the punch in gut (his analysis is on point and I agree with his conclusion).
I do not think I have ever read Taleb’s opinion on the All-Weather concept but I would guess he’s not a fan. The idea of being able to forecast each asset’s future return and risk is…intellectually very mediocristan.
But the “classic All-Weather” misses one of the key concepts from Nassim: convexity. Strategies like Trend Following and Long Vol offer great diversification from stocks and bonds beta while providing some of that ‘kick’ that Taleb loves in the high-risk portfolio. It is the same concept pushed by the Mutiny Fund guys, in particular their Cockroach Portfolio:
I bet that if presented with the above, Nassim’s comment would be “IMBECILE!” at best, and yet…here I am 🙂
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