Updated: 11 hours ago
In our article, Investment Thoughts For My Children, we recommend a barbell strategy for investing. You may wonder, “How does a barbell relate to investing?!” In this supporting article, we provide a helpful framework, examples, and the model describing our barbell strategy approach.
Our investment barbell background
First, 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 - This is 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. [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. To help us operationalize the risk and ruin difference in a practical investment framework, this article relies upon thinking from successful investors, economists, and authors. 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 Buffet is one of the world’s most famous and successful investors. One of Buffet’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 have the majority of our investable equity at the 4 corners (or 4 “bells”) of these two features. 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.
“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 table contains general investable equity distribution guidelines. As a reminder, investable equity is total value less any loan balance. For example, if you have a $500,000 home and a $400,000 mortgage, the investable equity to include in the guideline calculation is $100,000.
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.
Our investment barbell quadrant examples
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 a cash substitute. 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.
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. The robos generally use a highly diversified set of low-cost ETFs. In the notes, I provide an article link for more details on how robos work, tax-efficient strategies, how to think about costs, robos I use, robos I avoid, etc. [iv] Also, 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.
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 and hotel condos may be good alternatives for exposure to this segment.
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 that downside ruin is protected by the other 3 quadrants. Let's start by breaking down 2 important and very different kinds of risk. Those 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, etc.
Systemic risks are risks specific to the business market. These are risks that 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 are generally impacted by 1) climate tax policy or 2) the degree to which consumer preferences are sensitive to environmental concerns.
Generally, I 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
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. For me, I do not have the time or desire to research/chase the knowledge necessary to properly evaluate these risks.
Our investment barbell framework in action
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." Since the pandemic began, work and life have been pretty crazy, she has been super busy adapting to the "new normal." This is her first opportunity to complete a health check on her financial life. 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 quadrant 1.
She has 6 different financial portfolios, including retirement and taxable portfolios. Some she has rolled over from previous employers. This relates to quadrant 2.
She has 2 homes (a primary home and an investment property). This relates to quadrant 3.
She has some targeted sector investments. She invests in these primarily through ETFs. This is related to quadrant 4.
Berny's 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 reviewing 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 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 quadrant 2. This means she does have some funding capacity in quadrant 2.
Berny is significantly below the range for quadrant 4. This means Berny is likely leaving money on the table by being under-invested in quadrant 4.
Upon digging into the 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 quadrant 4.
Investment barbell framework recommendation:
Berny will divest 5% of her 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.
Berny will reallocate the banking ETF to quadrant 2, as this is the appropriate quadrant.
Berny will purchase a climate/alternative energy-related ETF with the funding from her quadrant 2 divestment. This ETF buys climate-related companies and is appropriate for 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.
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...
#1 - Being content with yourselves and NOT spending money you don't have, NOT buying things you don't need, and NOT impressing people.
#2 - Having a long-term focus (and long-term is NOT two or three years). Wealth and security are built over decades, not months.
#3 - Very simply - 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.
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