How To Build A Barbell Portfolio

by: Bram de Haas

Summary

Explanation of the barbell portfolio.

Taleb provides us with mostly abstract guidelines of how to construct it.

I outline my approach to put it into practice while adhering to the core principles.

I think that the first thing is you should have a strategic asset allocation mix that assumes that you don't know what the future is going to hold.

Ray Dalio

The concept of the barbell portfolio was devised by bond traders. The strategy entails holding extremely safe short-term bonds on one side of the barbell and risky long dated bonds on the opposite side of the barbell. Taleb popularized the concept to a wider audience and took it out of the bond market context.

Building a barbell portfolio, you slap on weights of extremely safe investments on one end and extremely risky ones on the other end. The safe investments carry with them virtually no risk of ruin. They are robust. Even in the face of Black Swans. The aggressive risk-seeking side of the portfolio opens it up to unlimited or sheer unlimited upside. Through this barbell approach, it is possible to build a portfolio that thrives under a variety of circumstances, including extreme ones.

Middle of the road type investments offering medium risk and return should be religiously avoided according to Taleb. These types of investments typically rely on extrapolating current returns a number of years into the future. Generally, the investment case relies on predicting a certain growth rate or return. When something unexpected happens like an accounting scandal or a disaster, you take a huge loss on these types of investments.

Extremely risky assets are usually known to be extremely risky so they are priced by the market with the expectation of loss of principal as a real possibility. The problem with the middle of the road investments is they are sometimes priced as if loss of principal isn't really a possibility. When it does happen due to an unforeseen Black Swan type of event, results are disastrous. When the Black Swan doesn't strike, you aren't really compensated for the risk you were exposed to in the meantime. Because risk is very much top of mind when investors consider extremely risky assets, these do offer compensation for the true risk the owner runs.

A common misunderstanding of Taleb's work (Incerto comes highly recommended) is to read it as if he's advocating 90% short-term treasuries on one side and OTM options on the other side. More on this later. Taleb keeps his work highly conceptual on purpose. There are many approaches you can take in practice (my approach taken in the Black Swan Portfolio doesn't usually involve options) as long as the implementation lives up to the goals for each side of the barbell.

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How to build the left side of a barbell portfolio

Taleb proposes the variations of the value of investments on the left of the barbell should not affect the welfare (defined as health, happiness and fortune) of the investor.

He allows for variations in the valuation of the left side holdings. If you take small positions, as per his suggestions, you can accept quite sizeable variations in the value of the assets on this side before your welfare is affected.

A 20% drop in a position that makes up 1/30th of the left of your barbell isn't going to affect your health, happiness or fortune very much. Even though they may exhibit volatility, it is important the left side holdings hold on to most of their purchasing power over time.

With a lack of easy prepackaged answers from his work, you will have to think for yourself how to design a solution in practice. It is paramount not to get greedy on the safe side because this will result in adding investments from the "middle."

The goal for the right side of a barbell portfolio

The goal for the right side of the barbell is to gain exposure to the upside. My choices for right side (offensive) investments usually consists of aggressive investments but no options. A common misunderstanding is reading Taleb as if he encourages us to buy OTM puts or other OTM options and bet on freak outcomes. That's not the case.

I can understand how these misconceptions are born, as he is a former options trader of 20 years and talks about options on virtually every page of his works. But it's not what he is saying.

He literally says:

acquire optionality without paying for it

A key message from Incerto.

Financial options are usually not free at all because people understand quite well what they are selling you. Instead, you should search optionality outside of the option market where people are much less adept at pricing these correctly.

This is not something every investor is used to and many overlook his actual message. Instead, they take the shortcut of thinking buy high risk assets with huge optionality must equal buying OTM options.

In fact, financial options are almost by definition extremely fragile. Fragility and Anti-fragility being other important concepts from Taleb's work. If you sell puts or calls, they can go against you and wipe you out in short order. They are extremely fragile to the passing of time.

If you can buy undervalued puts or undervalued calls or construct option exposures in a way you don't end up with a fragile portfolio and can capitalize on price efficiencies, sure include them in the mix, but it isn't my expertise or how I go after exposure to positive Black Swans.

Instead, it is much easier (as you aren't facing option professionals) to find optionality in common stocks.

An example of optionality in the stock market

Overstock (NASDAQ:OSTK) run by Patrick Byrne is a prime example of a barbelled business. It's a sturdy online retailer that grows slowly and sometimes in lumps as its owners refuse to engage in excessive spending on promotion. There is $170 million in cash and cash equivalents on the balance sheet versus a $340 million market cap at this time. The balance includes approximately $10 million in gold and some bitcoins.

At the same time, there is a whole segment, that's eating up a lot of the FCF from the retail business, that's focused on the emerging technology of the cryptocurrencies. The market underappreciates the sturdy retail business because its free cash flow is obscured by the aggressive investments made by Overstock. As it is completely unclear what return the investments in crypto technology are going to be, the market puts little to no value on them. I agree the ultimate outcome is highly uncertain but the payoff of something like t0 can be huge compared to Overstock's market cap.

Disclosure: I am/we are long OSTK.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.