The barbell investment strategy

According to modern portfolio theory and many other investment philosophies, successful investing is achievable by striking an acceptable balance between risk and reward. (See "The History of the Modern Portfolio.") For most investors, this entails cultivating a portfolio of securities that have intermediate risk characteristics and offer middle-of-the-road returns. Contrarily, an acceptable risk/reward balance may likewise be achieved with an entirely different paradigm known as The barbell strategy, which aims to usher in substantial payouts without taking on undue risk.

The barbell strategy advocates pairing two distinctly different baskets of stocks. One basket holds extremely safe investments, while the other only holds highly-leveraged and speculative investments. In other words, this method urges investors stay as far from the middle as possible.

This bifurcated approach famously allowed renowned derivatives trader and arbitrageur Nassim Nicholas Taleb to thrive during 2007 and 2008 economic downturn, while many of his fellow Wall Streeters took hits. Taleb described the barbell strategy’s underlying principle as follows:

"If you know that you are vulnerable to prediction errors, and accept that most risk measures are flawed, then your strategy is to be as hyper-conservative and hyper-aggressive as you can be, instead of being mildly aggressive or conservative."

• When applied to fixed income investing, the barbell strategy advises pairing short duration bonds with longer-term bonds.
• The success of the barbell strategy is highly dependent on interest rates.

In practice, the barbell strategy is frequently applied to bond portfolios. Unlike for equities, where the model endorses investing in stocks with radically different risk profiles, for fixed income, it advocates marrying bonds with variant maturity timetables. Therefore, instead of investing in intermediate duration bonds, the barbell method urges investors to favor a combination of short duration (under three years) and long duration (more than ten years) bonds.

While long-term bonds carry the obvious benefits of high-interest payouts, in order to make the short-term bonds fiscally beneficial, investors must proactively trade out maturing bonds for newer ones. This requires fixed investors to judiciously monitor and adjust their short-term bond portfolios, as maturity dates come and go.

Not surprisingly, the success of the barbell strategy is highly dependent on interest rates. With rising rates, the short duration bonds are routinely traded for higher interest offerings. But in the case of falling rates, the longer-term bonds can theoretically save the portfolio, because they lock in those higher interest rates.

For example, suppose an investor predicts the yield curve will flatten, and buys five 30-year bonds, while simultaneously buying five three-year bonds. With this strategy, the investor mitigates the risk associated with an adverse move in interest rates. Should rates fall, the investor may not have to reinvest funds at the lower prevailing interest rate, because they longer-term higher interest bonds, will carry them to overall profitability. However, if interest rates rise, the investor has an opportunity to sell their short-term bonds and reinvest the proceeds in longer-term bonds.

The optimal time to implement the barbell strategy for bond investing, is when there are large gaps between short- and long-term bond yields. This is predicated on the theory that the gap will eventually close and reach historical norms.

The barbell approach can be labor intensive, and it demands constant attention. Consequently, less hands-on investors may prefer the barbell strategy’s antithesis: the bullet strategy. With this approach, investors commit to a given date (say, bonds due to mature in seven years), and then they sit idle, until the bonds mature. Not only does this method immunize investors from interest rate movements, but it lets them invest passively, without the need to constantly trade out one bond for another.

In 2012, a Canadian investment firm developed an exchange-traded funds (ETF) designed to replicate the barbell bond strategy, comprising Canadian government bonds. In the future, American investment firms may follow suit. But until then, independent investors can fashion their own personal barbell bond ETF, simply by separately purchasing a short-term bond ETF and a long-term bond ETF from a brokerage. The bonds in the short-term ETFs will roll over automatically.

While the barbell strategy requires a modest level of sophistication regarding the bond market, those who take the time to study up, stand to gain. By pairing short-term and long-term bonds, while forsaking the middle ground, investors may achieve admirable returns, that are someone shielded from unduly rate-setting whims of the Federal Reserve.