2020 was a year in which extremes like gold and small caps did well as a investment strategy. Is it time for the middle to do better?
Define: Barbell strategy
The concept of the barbell investing strategy is that to get the best risk: reward ratio, your investments should look like barbell weights i.e. heavy investments in super safe assets and super risky investments with the idea that they will offset each other over time.
The idea was popularised by Black Swan author and former fund manager Nassim Taleb and has been touted since by famous investors including Ray Dalio and Mohammed El’Arian. The core concepts are those of risk and probability. You can visualise the strategy in terms of a normal distribution.
How to make a barbell strategy investing portfolio
Of course, no investor should assign a large portion of their portfolio to highly risky bets, so the advocates of the barbell investing strategy suggest using the 90/10 rule. 90% of the portfolio should be in ultra-safe cash-like instruments that are very safe and liquid. The other 10% should be in assets that have a real risk of loss of principal including things like cryptocurrencies, out of the money put options, venture capital bets or junk bonds.
The general idea of the barbell has now been extended to other ways of categorising assets in your portfolio other than by risk. For example a portfolio might have a growth/income barbell strategy or a junk bond / government bond barbell strategy etc.
Why the barbell was good in 2020
Because of the extreme environment caused by the pandemic in 2020, investors that took extreme positions appear to benefited the most. The simultaneous buying of havens like US treasuries and gold provided the safety against a financial crisis while buying into risky growth stocks that benefit from extra central bank liquidity and retail trader participation also did well.
In essence, the safe and the risky assets did well in 2020, meaning both ends of the barbell did well together. This is not actually how the strategy is supposed to work because one end of the barbell is supposed to hedge (or offset) the other.
We have annotated the chart below from BNPP to highlight the outperformance of certain safe and risky asset class in 2020. Arguably some of these traditional asset classes are not ‘very risky’ but do fit at the riskier end of the scale. Likewise, gold is deemed a haven asset but is still very speculative.
Looking specifically at equity indices, you can see it is the midcap stocks that have lagged while richly valued tech stocks and riskier small caps and emerging market indices have done the best.
Why might things be different in 2021?
Well they might not be. We are still in the pandemic and it appears central banks will keep liquidity available for most of the year – so there is every chance that a repeat of the 2020 barbell outperformance could continue through 2021.
However, should the real economy bounce back with the end of lockdowns, more hiring and lots of government spending – then the asset classes ‘in the middle’ that fell behind might have some room to catch up. Alternatively, should what many people are calling an ‘asset price bubble’ pop – it’s easy to see how some of the assets with the best returns would be some of the first to be sold in a scramble to cover margin calls and take profits. The best-performing assets are also very 'crowded trades' and with question markets over how well algorithmic traders perform as market makers under stress, there is a chance that low liquidity excereserbates any decline.
Finally, markets are forward-looking animals and even if the economy in 2021 follows the path set out last year, 2022 might have a whole new host of differences that investors need to price in this year with a different approach to the barbell.