The Barbell Investment Strategy

Introduction

There seems to be a great debate about the merits of "active" vs "passive" investing. You can't ask an investment strategy question on twitter or reddit without most of the comments warning you that it's impossible to beat the market, rather put your money into low cost index funds. This is for good reason - on a risk adjusted basis, more than 95% of active funds fail to beat their corresponding index benchmarks over a 20 year period.

No wonder the passive crowd beat that drum, it is incredibly hard to beat the market.

Hard, but not impossible.

There is ample evidence that the market is not efficient. Whether it's emotion, news, market cycles or external events, there are many factors that lead to mispriced stocks (both over- and under-valued). Herein lies the opportunity. If you can find an information edge, you can capitalize on these mispricings and generate significant returns.

Given these two facts - it's hard to beat the market and there are observable opporunities in individual stocks - how does one choose between the two?

Do you even have to?

Smart portfolio management means you don't have to put all your eggs in one basket. Rather than thinking of active vs passive investments as all in bets on a single strategy, think of it as a range where you can decide how active or passive you want to be.

The Barbell Investment Strategy

The philosophy of the barbell strategy lies in balancing two different investment approaches, generally low risk and high risk in nature. By allocating investments between these two poles, the strategy aims to mitigate the risks inherent in investing in higher risk assets while still capturing their potential for outsized returns. Simultaneously, the stable end of the barbell provides a safety net, reducing the overall volatility of the portfolio. This approach allows investors to pursue growth opportunities without exposing their entire portfolio to excessive risk.

Advantages of the Barbell Strategy

1. Risk Management: By balancing high-risk and low-risk investments, the barbell strategy provides a buffer against market volatility. The stability of low-risk investments can offset losses from the high-risk end during market downturns.

2. Potential for Higher Returns: The high-risk segment of the portfolio has the potential to generate significant returns, especially in bullish markets or when specific bets pay off.

Compared to other investment strategies, such as a pure passive or active approach, the barbell strategy offers a middle ground. It provides an opportunity to capture the upside of investing in individual stocks while mitigating risks through passive index funds.

Implementing the Barbell Strategy

Implementing the barbell strategy in the context of active and passive investments is a simple portfolio allocation exercise.

The conservative foundation of the portfolio is allocated to index funds and makes up 50% or more of the portfolio. Being passive, this portion of the portfolio is never sold, regardless of market conditions.

The active side of the portfolio is made up of individual stocks that never make up more than 50% of the portfolio's allocation. These assets can be actively traded based on market conditions.

Using this approach provides exposure to every stock at all times (passive portion) while simlutaneously allowing you to overweight individual stocks (active portion).

By using this approach, 50% of more of the portfolio will capture market average returns, while still providing the opportunity to outperform.

To Rebalance or Not?

Implementing this strategy provides a foundation from which successful investors can achieve market beating returns (assuming you pick the right stocks). In this scenario, the active portion of the portfolio will outperform the passive portion and might skew the portfolio towards active from the initial weightings. This raises the question of whether or not to rebalance.

Rebalancing

Rebalancing in the barbell strategy is a tactical decision, especially when the active portion outperforms the passive. It’s about resetting the portfolio to its original allocation, often requiring the sale of outperforming stocks to reinvest in the passive end. This can help maintain the intended risk profile and prevent the portfolio from becoming overly aggressive. However, rebalancing also means potentially cutting short the growth of your winning stocks, which can be a tough call for investors enjoying the ride of successful picks.

Let Your Winners Run, but Contribute in Line with Initial Allocations

An alternative approach (and my preferred one), is to let your winners run while continuing to contribute new funds according to the original allocations (50/50). This method allows the successful active investments to flourish, potentially driving the portfolio's overall performance higher. Simultaneously, new contributions are allocated uniformly between active and passive, maintaining a balance without disrupting the growth trajectory of your winning stocks. It's a way to harness the momentum of your active choices while steadily upholding the safety net of the passive investments.

Considerations

While implementing a barbell strategy, several considerations should be kept in mind:

1. Knowledge and Expertise: The active portion of the portfolio requires a degree level of financial literacy and understanding of the markets.

2. Time and Effort: Actively managing part of the portfolio, especially the individual stocks, requires time and effort to research, analyze, and monitor investments.

3. Emotional Discipline: The barbell strategy requires investors to maintain emotional discipline, especially during market fluctuations, to stick to the planned investment strategy.

Conclusion

The barbell investment strategy presents a balanced approach between active and passive investing, offering the potential for higher returns through well-researched active investments while maintaining a stable base with passive index funds. It is a great starting point for those looking to introduce active investments into their portfolio and provides the opportunity to outperform a passive only strategy.