Evaluation Of The Viability Of The Barbell Investing Strategy
Introduction
Background
Unexpected market events can happen with devastating impact to our portfolios. Financial shocks caused by rare events often have impactful consequences on investor wealth. Furthermore, predicting these types of events is often outside the ability of the current investment toolset. These events often are referred to as “Black Swans”, thanks in part to the investor turned author, Nassim Taleb, whose use of and success with the barbell strategy during the financial crises gained him much renown. The Barbell Investment Philosophy, however, is based on the occurrence of these black swans and their non-predictability. When faced with a market where massive swings, either positive or negative, can have a lasting impact, Taleb suggests that an investor’s only option is to be “both hyper-aggressive and hyper-conservative at the same time. ” (Taleb 2007) He goes on to recommend that an investor put 85-90% of their portfolio in the safest possible bets, T-bills, and the remaining 10-15% into extremely speculative and as highly leveraged positions as possible, preferably venture capital-style investments.
Problem Discussion
This inability to correctly assess the probability of these extreme economic shocks is due in large part to the assumption that the financial models are normally distributed. “Black Swans are in brief defined by rarity, extreme impact and retrospective predictability. ” (Taleb 2007) As investors, we are unable to accurately predict and incorporate the impacts of such shocks into traditional financial models, yet instead of accepting that this uncertainty cannot be quantified, investors continue to try to predict the future based on assumed known probabilities.
Literature Review
Black Swans
“The term “Black Swan” is a metaphor used to describe highly improbable events that are unpredictable and carry with them an extreme impact; in statistical terms a Black Swan represents an outlier and can have positive or negative impact. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact […] Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. ” (Taleb 2007)As an example, consider October 19, 1987, also known as Black Monday. “On this day, the Dow Jones declined by 22. 61%, almost twice as much as the largest previous decline of 13% that occurred in 1929. Black Monday was in terms of standard deviations an event of approximately 21 standard deviations above the mean and hence its probability of occurring was almost non-existent. ” (Bogle 2008) Although the Black Monday example is extreme, it does effectively illustrate the impact the improbably can have on investment performance.
Empirical Evidence
“From January 1978 to October 2005, the S&P500 index delivered a mean annual return of 9. 6 percent, however, by excluding the worst 50 days increases the mean return to 18. 4 percent, and by excluding the best 50 days lowers the mean return to just 2. 2 percent (Figures not accounting for dividends). ” (Mauboussin 2006) Estrada 2008 study concluded that such events have a massive impact on portfolio performance. The study shows that, “across 15 international markets, on average, missing the best 10 days resulted in a portfolio 51 percent less valuable than a passive index investment and avoiding the 10 worst days resulted in portfolios 150 percent more valuable than a passive index investment. ” (Estrada 2008) Thus leading to the conclusion that Black Swans have a more disproportionate impact than what is accounted for under normally distributed financial models.
Financial Models
The fact that conventional financial tools are incapable of computing adequate projections that incorporate Black Swans into the future is not a new discovery. In fact, researchers have known for quite some time about this issue. Taleb is just the most popular in a long list of research by those such as Mandelbrot (1963), Fama (1965), and Estrada (2009). The issue can therefore be summarized as assuming a known probability when in fact none exists. “Probability is subject to quantifiable risk, not to unquantifiable uncertainty. ” (Knight 1921; Taleb 2007) “More simply, according to Knight there is a distinction between risk, which is subject to probability (as with the roll of the dice in a casino), and uncertainty that is immeasurable and hence not subject to probabilities. ” (Taleb 2007) In the casino case there is the certain-uncertain, or the gambler is aware of the odds of the game but uncertain of its outcome. In financial markets, however, we observe that we are both uncertain of the risk of the game and therefore cannot know the probability, an uncertain-uncertain. “Certain-uncertain outcomes do not tell the whole truth in regards to future uncertainty when applied to financial models, and hence the estimation becomes the subject of an increasing bias. ” (Knight 1921)
Investing Strategy
To restate a previously mentioned point, Taleb recommends that an investor put 85-90% of their portfolio in the safest possible bets, T-bills, and the remaining 10-15% into extremely speculative and as highly leveraged positions as possible, preferably venture capital-style investments. (Taleb 2007)
CriticismsThe Barbell
Strategy comes with the obvious downside of being subject to sustained “bleeding” during long stretches of financial stability. There is also no timeframe that exists for how long an investor may have to wait given the uncertainty of Black Swans. “This fact leads to potential scenarios where, if that strategy is applied in a managed fund, the manager faces the impending risk of getting fired before returns arrive: large scale withdrawal of funds making the strategy undesirable; and even if both manager and investors understand the nature of the strategy and are dedicated to it, the aggregation of losses over time might lead to insolvency and termination. ” (Malliaris & Yan 2009) Before continuing on to part 3, it is prudent that we mention that the Barbell Strategy will be entirely dependent upon the timeframe during which you invest. If this period consists of a high number of Black Swan events, then fund profitability could be expected. If the opposite is true, however, then ultimately investors will experience major aggregate losses over an extended period of time, i. e. “bleeding. ” What is Barbell Strategy?According to NASDAQ, Barbell strategy refers to a fixed income strategy in which the maturities of the securities included in the portfolio are concentrated at two extremes. For example, a portfolio manager invests in short and long duration bonds but not in the intermediate duration bonds.
According to Investopedia, Barbell is an investment strategy relevant mainly to a fixed-income portfolio, in which half the portfolio is formed up of long-term bonds and the other half of very short-term bonds. The “barbell” term is developed from the fact that this investing strategy is similar a barbell, massively weighted at both ends and with nothing in between. The barbell strategy in fixed income is the contrary of a “bullet” strategy, in which the portfolio is thought about closely in bonds of a specific maturity or duration. Enter the Barbell Investment StrategyThe barbell strategy is a method that makes an effort to protect the best of both worlds. It’s possible to obtain considerable payouts without taking on excessive risk. The strategy’s basic official instruction is giving attention to that it’s not only unreasonable to a populace weaned on the benefits of tempering risk and reward, it’s clear in meaning that: Stay as far from the middle as possible. The barbell strategy was founded by Nassim Nicholas Taleb, a derivative trader and arbitrageur. His strategy was famous in 2008 during the Global Financial Crisis, since it generated extremely large profits for him while most of the traders was hurting with extremely loses. If you know that you are vulnerable to estimation errors, and receive that most “risk measures” are fault, then your strategy is to be as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative. " Put your eggs in two baskets. One basket holds largely secure investments, while the other holds nothing but leverage and speculation.
How to set up the Barbell Strategy
When Taleb introduced the barbell strategy, he did so in manner that emphasizes a particular thought exercise more so than a verbatim outline of what to invest in. There have been several investors who have sought out to create their own versions of his ideas, and our research will reflect upon the findings of those. First, we will outline what the risk-free component of the barbell should be composed of, and then later we will spend a great deal more time analyzing the high risk portion. Taleb recommends that the risk-free portion of the barbell be composed of thing that are “anti-fragile” or more simply the opposite of things that tend to become more robust in the face of volatility, randomness, disorder, and stressors in the market. For our research’s purposes we will take this to mean treasury bills and gold. Treasury bills are self-explanatory in their risk, however, the use of gold allows us to account for any errors in central banking policy. In practice, we would use an ETF for ease of cycling through one year treasury bills, but for research purposes we will just use the general returns over a time series of N. Now let’s examine, the more complex and time intensive risky portion of the asset allocation.
For this portion, it is recommended that investors allocate with securities or derivatives that have what Taleb describes as optionality. Optionality can be defined as investments that have high positive risk and limited negative risk. For most, this conjures ideas of buy-side derivatives, but that is not the only option that an investor might choose to follow. For instance, one might also make use of venture capital market and its relatively low barriers to entry, or even some private equity arrangements. However, the available data to back test these options is limited to (1996 for options) and virtually non-existent in venture capital and private equity. Therefore, we will rely on secondary research performed on these investments, and use small cap equity with a lower mix of risk-free assets to see if we cannot create a similarly viable strategy.
Fixed-Income Barbell
There are only short-term bonds and long-term bonds, which are needed for a portfolio manager to implement the barbell strategy investment, with no intermediate duration bonds. The barbell is for the active investor, as it needs frequent tracking in order to see how it develops, so that you can make any necessary changes, since the short-term bonds must be frequently turned over into other short-term instruments as they arrive at maturity. By investing heavily in less than one year bonds, the quickly arriving maturity dates mean that the investor must always reinvest the proceeds. Short-term bonds need to be found, evaluated, and acquired once the last series of short-term bonds matures. Likewise, the weightings for the bonds or assets on either side of the barbell are not fixed at 50%, but can be changed slightly to make it more suitable for market conditions as required.
For example, an investor uses a barbell strategy for his portfolio because he thinks that the yield curve will flatten. He forms the portfolio by buying five 30-year bonds and five three-year bonds at the same time. With this strategy, the investor alleviates the risk associated with an opposite move in interest rates. If interest rates decline, the investor may not have to reinvest funds at the lower prevailing interest rate because he has long-term bonds with higher interest rates. However, if interest rates increase, the investor has a chance to sell their short-term bonds and reinvest the proceeds in longer-term bonds. Assume interest rates increase by 1% and the short-term bonds are expired next month. The investor could hold on to his short-term bonds until maturity and reinvest her gains into longer-term bonds at the higher prevailing interest rate.
Asset Allocation Barbell
The barbell strategy is also more and more all the time applied with reference to stock portfolios and asset allocation, with half the portfolio anchored in defensive, low-beta sectors or assets, and the other half in aggressive, high-beta sectors or assets. The conventional notion of the barbell strategy requires investors to hold very safe fixed income investments on one end of the portfolio, and high-risk securities on the other end.
For example, an asset allocation barbell may consist of 50% protected, conservative investments such as Treasury bills and money market instruments on one end, and 50% high-beta investments, such as emerging market equities, small- and mid-cap stocks, and commodities–on the other end. If market belief is very bullish, as for example at the beginning of a broad rally, the investments at the aggressive end of the barbell will typically perform well. As the rally goes on and market risk goes up, the investor may wish to book gains and trim exposure to the high-beta side of the barbell. The investor would therefore sell, for example, 5% of the high-beta portfolio and allocate the proceeds to the low-beta end, so that the allocation is now 45% (high-beta) to 55% (low-beta).
Why Barbell Strategy?
The barbell strategy attempts to get the best of both worlds by combining low-risk and high-risk assets and getting better risk-adjusted returns in the process. The potential benefits of a barbell strategy are: + Greater diversification than a bullet strategy: Offering better diversification than a bullet approach, and reducing risk while retaining the potential to obtain higher returns. If rates rise, the investor will have the opportunity to reinvest the proceeds of the shorter-term bonds at the higher rate. The short-term securities also provide liquidity for the investor and flexibility to deal with emergencies since they mature frequently. + For most investors, that acceptable balance means positioning oneself somewhere in the comfortable middle. Invest in securities of intermediate risk and intermediate return, and no one will ever strongly criticize you for wasting your life’s savings, nor for taking too modest a return. The median is the socially prudent place to be. But is it the most financially rewarding one?
Risks from Barbell Strategy
There are some risks for investorimplementing the barbell strategy. Firstly, the fundamental risk of this strategy lies in the longer-term end of the barbell. Long-term bonds are likely to be much more volatile than their short-term counterparts, so there is the possible for capital losses if interest rates increase (as prices decline) and the investor chooses to sell the bonds earlier to their maturity. If the investor has the ability to hold the bonds until they mature, the effect of fluctuations won’t have a negative impact. Furthermore, the worst-case scenario for the barbell is a “steepening yield curve”. The long-term bond yields are increasing (and prices declining) much faster than the yields on short-term bonds. In this situation, the value of the long end of the barbell falls in value, but the investor still may be pushed to reinvest the proceeds of the shorter end into low-yielding bonds. The adverse of the steepening yield curve is the flattening yield curve, where yields on shorter-term bond increase faster than the yields on their longer-term counterparts. Moreover, it is not easily to implement the barbell strategy with small investment amounts to achieve diversity. Additionally, another drawback of the barbell strategy is that it keeps away from the middle road, such as intermediate-term bonds in a fixed-income barbell, and medium-risk investments in a stock or asset allocation barbell. This may not be the best course of action at certain times of the economic cycle when intermediate-term bonds and medium-risk investments tend to outperform.
