We often hear that investment diversification is super important to long-term wealth accumulation. We also intuitively understand risk and return go together. In general, you cannot achieve the level of return you want without taking a commensurate risk. To get a high return - you need to take high risk. If you are only comfortable with less risk - you will achieve less return. Risk and time are like two sides of the same coin. Understanding risk in the context of time is essential. The future is the playing field.
But how are risk and return defined and how do we achieve our goals!? We all want to make more money... but how do we do so given the risk we are comfortable with? How do we expand the risk we are comfortable with? How is time synonymous with risk? The barbell strategy provides an actionable framework to think about this and the tools to do it. Think of the barbell approach as a way to manage our emotions and to take the risk we are comfortable with -- but in a way that best achieves our return objectives.
Using the barbell approach helps you build successful investment habits. These habits are summarized with the handy acronym called "the M-T-P":
The M-T-P
Motivation grounding: Be content with yourself, don’t spend money you don’t have, don’t buy things you don’t need, and don’t focus on impressing people.
Time frame setting: Have a long-term focus (and long-term is not two or three years). Wealth and security are built over decades, not months.
Process implementing: Save → Invest → Evaluate → Rebalance → Repeat.
First, you may wonder, “How does a barbell relate to investing?!” In this article, we provide a helpful framework, examples, and the tools to implement our barbell strategy approach. Our goal is all about DOING! The investment barbell strategy provides an action-oriented framework for individual investors to:
Appropriately manage BOTH diversification AND volatility-born risks.
Make time your friend for managing risk.
Define quadrants of investments aligned with typical life goals, like homeownership.
Provide quadrant weighting suggestions to optimize the risk-return tradeoff.
Furnish resources and feedback from world-renowned economists and investors to help enhance your personal finance confidence.
Give examples and decision tools to practically implement the investment barbell strategy.
Encourage a "process not perfection" mindset. We provide a "health check" tool to assist in identifying and making mid-course corrections.
Assess the various investments we typically engage in throughout our life.
Provide a repeatable, consistent investment decision process useful for all our investments.
Table of contents:
Introduction
The investment barbell background - How NOT to be your own worst enemy
The investment barbell defined - a lifetime of good investments
The investment barbell in action - Berny's case study and health check
Conclusion - You've Got This!
Notes and resources
2. The investment barbell background - How NOT to be your own worst enemy
A time-tested investing truism is that risk and return are correlated. The higher the risk, the higher the potential return. On the flip side, the lower the risk, the lower the potential return. When constructing a portfolio, risk and return have a statistical nature to them. Notice I said "potential return." That means, there is no guarantee. This is where the statistics help by constructing a number of investments called a portfolio. A portfolio of investments helps us achieve optimized risk and return outcomes via risk features known as diversification and volatility. But before we get into the features, let's discuss why the barbell approach is important when constructing portfolios.
The barbell investment strategy explained: Selecting all investments in the middle of the risk target will sub-optimize your target long-term risk and return. To optimize risk and return, the investor should use a barbell investment strategy. The idea of the barbell is that you build a portfolio at each end of the risk spectrum (high and low) to average the desired risk. To get the visual, think of a barbell and each side - high and low - are the weights. In the following examples, "medium risk" is used as the desired level of risk. But, this could be for any desired risk level.
Example 1 - we explain the NOT Barbell - or the wrong way to construct a portfolio:
The uninformed investor strategy construction - If all investments are filtered as medium risk, then → Risk = Medium, Return = Low: The idea is that if you put all your investments through a “medium risk” filter, while you may achieve medium risk, you will actually achieve a lower than the medium return. This is because statistically, the best return investment will be capped at a medium return, and some investments will not do as well. Capping the upside reduces overall portfolio performance. So, the return averages to less than a medium return. This effectively averages down the medium-risk investment selections to a less-than-medium return.
The uninformed investor strategy outcome: a sub-optimal risk/return tradeoff.
Example 2 - Now, explained is the correct way to construct a portfolio:
The barbell strategy construction - If all investments are filtered as either high or low risk to average medium risk then → Risk = Medium, Return = Above Medium: In a barbell strategy, you average your medium risk by investing to the edges of risk, both high and low. But then the return on the high-risk portfolio is uncapped upward, whereas the downside risk is capped at zero. In this barbell scenario, a medium risk averaged barbell will likely return ABOVE medium returns. The essential understanding is that to achieve the return you want, you must be comfortable taking higher risks, but only sometimes. Later in the article, we discuss commitment devices as a way to manage your emotions and implement the strategy.
The barbell strategy outcome: By using the barbell approach, the investor will achieve the same risk level and achieve a higher return. This is an optimized risk/return tradeoff.
Next, there are two major investment features we consider for our barbell strategy. Those barbell features are diversification and volatility. Through the lens of those two features, we separate our investments into 4 quadrants. To optimize our risk-adjusted return, we want exposure to each of these barbell quadrants. The following defines the features and the barbell quadrants:
Green: Well diversified and not volatile - Mostly cash, bank deposits, and low-risk/liquid investments.
Yellow: Well diversified and highly volatile - This is mainly Robo-advisor or related diversified portfolios, including regular rebalancing and tax-efficient strategies. You may certainly use a human investment advisor, but they may unnecessarily cost you more. [i]
Yellow: Not well-diversified and not as volatile - This is primarily real estate or REITs. (Do not know what a “REIT” is? Don’t worry about it. Just tuck it away…. you may want to learn more at some point.)
Red: Not well-diversified and highly volatile - This is individual projects like stocks, partnerships, business ventures, and target sector investments.
These heat-related colors are inclusive of both risk and return. For risk, green is the lowest risk and red is the highest risk. As an important guiding principle, our objective is not to eliminate risk! Our objective is to manage risk and eliminate ruin. [ii] This investment barbell strategy is devised to help you maximize your risk-adjusted return. This is done via exposure to all four quadrants. While the strategy will not eliminate risk, it will eliminate ruin.
Understanding the difference between risk and ruin is very important. This article relies upon thinking from successful investors, economists, and authors to help us operationalize the risk and ruin difference in a practical investment framework. N.N. Taleb is a bond trader, risk management, and philosophy author. One of my favorite Taleb reminders is:
"One may be risk loving yet completely adverse to ruin."
Warren Buffett is one of the world’s most famous and successful investors. One of Buffett’s sage risk management quotes is:
“Don't test the depth of the river with both your feet...”
The barbell quadrant colors also represent return potential, with red having the highest return potential, and green being the lowest. The idea with the barbell is that we deploy our investable equity at the 4 corners (or 4 “bells”) of these two features. A little later, we will suggest a weighting distribution for each bell quadrant. This will maximize risk-adjusted return. "Investable equity" is the value of a portfolio or investment after loans are netted. (Investments like a home or an investment account.) Note, that over half of your investable equity will be in a volatile strategy. As such, at times, these portfolios may lose value. This may be uncomfortable. You will need to stick to the strategy, even in down markets. Down markets likely provide the opportunity to average down costs. While it may seem difficult to buy into down markets, you will need to get used to this. We discuss this more in our article: Zoom out! A time-tested approach for investing in challenging markets.
“There is growing evidence that most people would be better off not paying attention to the ebbs and flows of the stock market.”
- Richard Thaler, University of Chicago Economist and Nobel Laureate
Using the auto transfer to a robo-advisor is a simple "commitment device." [iii] If you are still not comfortable with volatility, a human financial advisor may be a worthwhile alternative. While they are much more expensive than a robo-advisor, a robo-advisor will not be able to soothe your nerves!
The following graphic shows general investable equity distribution guidelines. As a reminder, investable equity is the total value less any loan balance. For example, if you have a home worth $500,000 and a $400,000 mortgage, the investable equity to include in the guideline calculation is $100,000.
Optimizing investment risk and return requires a weighted quadrant approach. In the next graphic, we show the proportional investment of your investible equity in each quadrant, varying from high to low diversification or volatility risk. The ESSENTIAL takeaway is that the twin risks are managed via the proportion of investment. As we discussed earlier, the RIGHT way to invest is to vary the proportions across higher or lower-risk quadrants to average your overall risk preference. The WRONG way to invest is by requiring all investments to conform to your overall risk preference.
Also, this guideline is flexible as to the life stage. For example, younger people may have more investable equity in real estate when they buy their first home. Thus, segment 3 may be at the high end of the range. The idea is to evaluate where you are and make planning adaptations over time. The underlying operating premise of this framework includes an evolutionary, error-correcting mindset:
“Progress, not perfection.”
3. The investment barbell defined - a lifetime of good investments
Introduction: Next, we define the 4 barbell quadrants. A "quadrant" is above the "portfolio" level. A "portfolio" is above the "individual investment" level.
Quadrant level: Think of the quadrant level as our strategy. You seek accuracy in the strategy when deploying your overall investment strategy. Think of the quadrant as a light beacon. You want to move toward the light! You need to own your investment strategy. This article helps you feel confident and provides tools to make periodic course corrections.
For example, your Robo Quadrant beacon is to invest between 40% to 60% of your investible assets in well-diversified, volatile investments. As such, do your best to move toward the Robo Quadrant beacon!
Portfolio or individual investment level: Your portfolio or individual investment is where the work gets done to implement the strategy. If you play your cards right, the work is done by highly trained robots! Implementation is where you seek precision. Sometimes, we recommend implementing the strategy at the portfolio level. (like the Robo Quadrant or the Fun Quadrant) Sometimes you may implement it at the individual investment level. (like the Real Quadrant or the Cash Quadrant) Below, each quadrant description, we recommend a particular investment level for deployment. You may need to change this depending on your situation and your available time and expertise. The key is being honest about your situation and your available time and expertise to enable implementation precision.
In general, there are low-cost solutions, like robo-advisors, providing low-cost and precise implementation assistance. For individual real estate purchases, realtors can be helpful, especially for first-time homebuyers. Being your own buyer's agent is certainly an option. Professional Personal Finance Advisors (PFA's) can be helpful for people with complex financial and tax situations. For normal people, robo-advisors or direct ETF purchases should be fine.
"Cash" Quadrant 1 - Cash is pretty straightforward. Personally, I am not a big fan of cash. I see a large cash balance as an opportunity cost. To some degree, I see other low-cost borrowing alternatives as cash substitutes. Not everyone feels the same way. The main value of having some cash and access to low-cost capital is for capturing unexpected opportunities. Cash/access to low-cost capital will also help if needed in an emergency. Access to low-cost capital could be an unused home equity line of credit. For cash, I typically use FDIC-insured High Yield Savings accounts. I shop these on financial sites like Bankrate and NerdWallet. I also may use a CD laddering strategy. To dig deeper into managing our segment 1 cash and liquid assets, please see our article: The sleeping bank deposit customer - It is time to wake-up
Recommended investment level = 3 (such as individual bank deposits)
"Robo" Quadrant 2 - Diversification is very important. One of my favorite Peter Bernstein quotes is:
“Well informed investors diversify because they do not believe that investing is a form of entertainment.”
In this quadrant, the vast majority of my strategy portfolios are in robo-advisors. I generally assign a high-risk tolerance when setting up the robo account. I am comfortable with high-risk robo portfolios. In my experience:
Time will heal financial wounds, but only in well-diversified portfolios.
The robos generally use a highly diversified set of low-cost ETFs. In our article Budgeting Like A Stoic, we provide links for more details on how robos work, tax-efficient strategies, how to think about costs, robos I use, robos I avoid, etc. [iv] Also, choosing the best robo-advisor for you is important. Please see our decision-making app to help decide on the best robo advisor:
Much of this segment I accumulated through the years via 401(k)s or rollover IRAs. As I mentioned in the Budgeting Like A Stoic article, we should all look to maximize the incredible advantages of 401(k)s, IRAs, and employer matching.
Recommended investment level = 2 (such as robo advisors managing portfolios of ETFs, or ETFs managing portfolios of securities)
"Real" Quadrant 3 - Real Estate certainly has advantages. Housing has obvious utility as the place to raise our family and make a home. Even though the U.S. tax code periodically changes to reduce some of the tax benefits of homeownership, it is still a good tax deal. Notwithstanding big crises, like the 2007-08 Financial Crisis and the pandemic beginning in 2020, housing remains a low volatility store of value and homes consistently appreciate in the long term. In fact, since the beginning of the pandemic, housing has been appreciating the fastest it ever has. Unfortunately, this has created some affordable housing difficulties, making it harder for first-time homebuyers to get on the housing escalator. But once on it, the long-term results are generally positive. To me, a significant value of housing is that it enables incredibly inexpensive access to capital. As found in the notes, we discuss our strategy to arbitrage housing-related borrowing to gain a positive gross interest margin on investments. [v] This strategy is not for everyone, but it has certainly worked for me.
Also, investment housing is often a good tax shelter. Think of an investment property as a stand-alone business. Related expenses may be netted against rental revenue to decrease your tax liability. This may come in handy. I have found though, one needs to be patient, as it may take years or even decades to reach positive net cash flow. For those that are time-constrained to manage real-estate projects, REITs, real estate investment funds, and hotel condos may be good alternatives for exposure to this segment. To dig deeper into real estate investing, please see our article: Homeownership is an important wealth-building platform. In this article, we explain how to use Definitive Choice for a lifetime of great homebuying decisions.
Recommended investment level = 2 or 3 (such as individual real estate investment projects, real estate investment funds, or REITs.)
"Fun" Quadrant 4 - Think of Quadrant 4 as our "fun money." This is investable equity we expose to higher volatility and higher diversification risk, with confidence the other 3 quadrants protect that downside ruin. In the high diversification and volatility risk "Fun" Quadrant, there are two additional risks to consider. Those two additional risks are Systemic Risk and Idiosyncratic Risk.
Idiosyncratic risks are risks of individual projects or companies. They are business entity-specific risks, specific to management, geography, operating systems, financial sophistication, risk management focus, sensitivity to news, etc.
Systemic risks are risks specific to the business market. These risks are generally similar for all business entities participating in a particular market. For example, in climate or alternative energy-related markets, all business entity participants may be impacted by 1) climate tax policy or 2) the degree to which consumer preferences are sensitive to environmental concerns.
For my Fun Quadrant 4 investment approach, I generally seek exposure to systemic risk and avoid idiosyncratic risk. For example, below are markets I have systemic risk exposure via ETFs:
Climate / alternative energy market
Nuclear Power market
Marijuana / CBD market
Blockchain Technology market (not crypto)
Disruptive Technology market
Based on my research, I believe exposure to these investment segments will provide above-average long-term returns. Some may seek exposure to idiosyncratic risk from individual investments. For me, I do not have the time or desire to research/chase the knowledge necessary to properly evaluate and/or trade idiosyncratic risks. This is a personal choice. My advice is to be “real” about your ability to manage Fun Quadrant 4 idiosyncratic risk. There are highly compensated professional traders that prey on the “fish” (inexperienced) traders in any market.
Recommended investment level = 2 (such as the target investment funds mentioned earlier.)
4. The investment barbell in action - Berny's case study and health check
In this section, we will describe Bernadette's use of the investment barbell framework. Bernadette, or Berny for short, has older children. She has a long-time partner, is college-educated, and has worked in the technology industry for much of her adult life. She is in her late 40's. She is starting to think about retirement but has no immediate plans. Berny does consider herself a financially sensible person. She does use robo-advisors, ETFs, and her company's 401k plans. She has been using the investment barbell framework as a way to guide her financial strategy. She periodically does a quick "health check." Berny's life is dynamic plus investments tend to change, so it is good to periodically step back and confirm her financial life is in alignment. At the end of this article, is a model spreadsheet Berny uses for her financial health check.
To start, she updates the input section of the spreadsheet. This is readily available information about her different portfolios. For Berny:
She has cash in a few accounts. She roles up the balances into one line item on the spreadsheet. This relates to Cash Quadrant 1.
She has 6 different financial portfolios, including retirement and taxable portfolios. Some she has rolled over from previous employers. This relates to Robo Quadrant 2.
She has 2 homes (a primary home and an investment property). This relates to Real Quadrant 3.
She has some targeted sector investments. She invests in these primarily through ETFs. This is related to Fun Quadrant 4.
Berny sensibly minimizes using debt to finance depreciating assets. For example:
cars -> she only pays cash for inexpensive cars, and
household goods -> she buys low-cost home furnishings. This enables her to pay off her credit card balance every month.
She has a good idea of what her real estate investments are worth by reviewing Zillow. She looks up the mortgage balance via her mortgage lenders. She also understands their income efficiency by checking last year's tax return. For her financial assets, she understands all the robo advisors are "well diversified." She also understands volatility by reviewing the risk rating she assigned when she opened the robo-advisor or 401k accounts.
Finally, for all her portfolios, she subtracts any loan balances to measure investable equity. For Berny, she only has loans on her real estate investments. I encourage you to download the spreadsheet so you can see Berny's example. You are welcome to use the spreadsheet for your own health check.
After entering and validating the information, the model calculates a total investable equity balance of about $5.2mm. The following is the investment barbell framework outcome report:
Investment barbell framework analysis:
I will compare Berny's outcome report to the distribution guidelines earlier in this article.
Berny is at the upper edge of the Cash Quadrant 1 cash guideline. She could probably stand to deploy some of that cash in another strategy.
Berny is "at range" for Quadrants 2 and 3. This is good, though she is at the upper end of the range for Robo Quadrant 2. This means she does have some funding capacity in Robo Quadrant 2.
Berny is significantly below the range for Fun Quadrant 4. This means Berny is likely leaving money on the table by being under-invested in Fun Quadrant 4.
Upon digging into the Fun Quadrant 4 ETF holdings, Berney determines one of the ETFs is for banking. She no longer believes banking is appropriate for the high volatility, low diversification quadrant.
She also has determined a new ETF portfolio, for climate change and ESG-related business is appropriate for Fun Quadrant 4.
Investment barbell framework recommendation:
Berny will divest 5% of her Robo Quadrant 2 portfolios. She will prioritize selling to minimize the tax impact. She will do this by selling 1) her IRA-based accounts to avoid current tax issues, or 2) through taxable robo-advisor accounts as they are well suited to manage the tax impact of a sale. Keep in mind that to maintain the retirement account tax advantage, the funds will need to be reinvested within a retirement account structure.
Berny will reallocate the banking ETF to Robo Quadrant 2, as this is the appropriate quadrant.
Berny will purchase a climate/alternative energy-related ETF with the funding from her Robo Quadrant 2 divestment. This ETF buys climate-related companies and is appropriate for Fun Quadrant 4. It has systemic exposure to the climate / alternative energy market but minimizes idiosyncratic risk by having low individual company concentrations.
Berny’s investment barbell strategy health check provides straightforward actions to 1) help Berny reallocate her investable assets and 2) provide peace of mind. This will help her get the best risk-adjusted return.
5. Conclusion -You've Got This!
Building an effective investment barbell strategy is not difficult. The outlined concepts are accessible to all. It does not require extensive financial education or deep investment knowledge. It does require the use of common investment tools like robo-advisors, ETFs, or the tools provided by your employer. It also requires periodically updating information from digital sources and your existing accounts.
Most importantly, this strategy's success is based on your long-term commitment and discipline. We encourage you to use auto transfer and related “commitment devices” as an easy way to maintain your discipline. Periodically, it is good to perform a health check to confirm alignment with the investment barbell framework guidelines.
Finally, as we suggest in the "Investment Thoughts For My Children" article, building successful investment habits is as easy as 1-2-3...using the M-T-P:
The M-T-P
Motivation grounding: Be content with yourself, don’t spend money you don’t have, don’t buy things you don’t need, and don’t focus on impressing people.
Time frame setting: Have a long-term focus (and long-term is not two or three years). Wealth and security are built over decades, not months.
Process implementing: Save → Invest → Evaluate → Rebalance → Repeat.
You’ve Got This!
Notes and Resources
[i] Hulett, Using the Stoic's Arbitrage to choose a great investment advisor, The Curiosity Vine, 2021
[ii] "Ergodicity" is important to understand the nuanced but important difference between risk and ruin. The following article provides ergodicity context and examples, including investing and gambling.
Hulett, Managing risk and avoiding ruin: The Ergodicity View, The Curiosity Vine, 2020
[iii] Thaler, Sunstein, Nudge, The Final Edition, 2021
I’m a big fan of commitment devices. This book does a great job describing commitment devices in the context of “choice architecture.” Being mindful of your choice environment is very important.
[iv] Hulett, Budgeting like a stoic, The Curiosity Vine, 2021
[v] Hulett, The Stoic’s Arbitrage: A survival guide for modern consumer financial services products, The Curiosity Vine, 2020
The essence of this arbitrage is to invest low-interest, long-term mortgage funding in higher-yielding long-term investments.
The Stoic's Arbitrage: Your Personal Finance Journey Guide
Core Concepts
Making the money!
5. Career choices - They kept asking about what I wanted to do with my life, but what if I don't know? - Part 1
6. Career choices - They kept asking about what I wanted to do with my life, but what if I don't know? - Part 2
7. Career success - Success Pillars - A Life Journey Foundation
8. Career choices - Do I need to be a Data Scientist in an AI-enabled world?
9. Career choices - Diamonds In The Rough - A perspective on making high impact college hires
Spending the money!
10. Budgeting - Budgeting like a stoic
11. Home Buying - Homeownership is an important wealth-building platform
12. Car Buying - Cutting through complexity: A car buying approach
13. College choice - The College Decision - Framework and tools for investing in your future
14. College choice - College Success!
15. College choice - How to make money in Student Lending
16. Event spending - Wedding and event planning guiding principle
Investing the money!
Pulling it together!