Barbell Investment Strategy

The barbell strategy is an investment concept that suggests that the best way to strike a balance between reward and risk is to invest in the two extremes of high risk and no risk assets while avoiding middle-of-the-road choices.

All investing strategies involve seeking the best return on investment that is possible given the degree of risk that the investor can tolerate. Investors who follow the barbell strategy insist that the way to achieve that is to go to extremes.

For most investment strategists, creating a portfolio begins with identifying the degree of risk that the investor can tolerate. A young professional may be ready to take on plenty of risk. A retiree may depend upon a steady income.

So, the strategist creates a portfolio that divides the money into three or more pools, each representing a category of risk. Speculative stocks such as initial public offerings (IPOs) or small biotechnology companies are highly risky. Blue-chip stocks are less risky but still vulnerable to the ups and downs of the economy. Bonds are safer, and bank certificates of deposit (CDs) are the safest of all.

That young investor might put 40% in speculative stocks, 40% in blue-chip stocks, and just 20% in bonds. The retiree might keep 80% in bonds and 20% in blue-chip stocks. Each is pursuing the best possible return for the appropriate level of risk.

Followers of the barbell strategy would argue that the middle of the risk spectrum should be ignored.

The barbell strategy advocates pairing two distinctly different types of assets. One basket holds only extremely safe investments, while the other holds only highly-leveraged and speculative investments.

This approach famously allowed Nassim Nicholas Taleb, a statistician, essayist, and derivatives trader, to thrive during the 2007-2008 economic downturn while many of his fellow Wall Streeters floundered.

Taleb described the barbell strategy’s underlying principle this way: "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."

In practice, the barbell strategy is more frequently applied to bond portfolios.

For investors in high-quality bonds, the greatest risk is losing out on an opportunity for a better-paying bond. That is, if the money is tied up in a long-term bond, the investor won't be able to put that money in a higher-yielding bond if one becomes available in the meantime.

Short-term bonds pay less but mature sooner. Long-term bonds pay more but have greater interest-rate risk.

Thus, in bond investing, the opposite extremes are short-term and long-term issues. There isn't much incentive to stick to the middle of the road.

Unlike for equity investors, where the model endorses investing in stocks with radically opposite risk profiles, the model for bond investors suggests mixing bonds with very short (under three years) and very long (10 years or more) timetables.

That gives the investor the opportunity to exploit higher-paying bonds if and when they are available while still enjoying some of the higher returns of long-term bonds.

Not surprisingly, the success of the barbell strategy is highly dependent on interest rates. When rates rise, the short duration bonds are routinely traded for higher interest issues. When rates fall, the longer-term bonds come to the rescue because they have locked in those higher interest rates.

The optimal time for bond investors to implement the barbell strategy is when there are large gaps between short- and long-term bond yields.

Even for bond investors, the barbell approach can be labor-intensive, and it demands frequent attention.

Some bond investors might prefer the barbell strategy’s antithesis: the bullet strategy. With this approach, investors commit to a given date by buying bonds that are all due to mature at the same time, say in seven years. 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 re-invest their money.