Risk Mitigation with a Barbell Portfolio

It is extremely common for investors today, even those with professional financial advisers, to follow a version of buy-and-hold indexing portfolios with standard ETF or mutual fund products.

Invest 60 percent (or more) of your money in diversified equities and 40 percent (or less) in bonds to achieve a target return with a reasonable amount of risk. Re-balance annually. Hold for life. These types of portfolios have provided investors with 8-10 percent annual returns averaged over the past decades.

Many investors use period backtesting to justify further spins on this basic model. Go all U.S. stocks, allocate an outsized portion to small-cap value stocks or emerging market stocks. Use equal weight indices instead of cap-weighted indices. Or pursue other niche equity factors to try eek out small extra returns.

With most of the focus on the equity side, bonds are often overlooked. Generally investors will choose a broad bond fund, which includes Treasury bonds and investment grade corporate bonds. Others choose just Treasury bonds. Again, there are minor adjustments to this standard: adding international bonds, tilting to long-duration Treasury bonds, and so on.

Much of this standard, run-of-the-mill advice is based on lengthy backtests. While investors quote long-term returns of 8-10 percent annually, very few years actually would have seen those return figures.

The chart below shows what investors believe the returns look like in this type of investing model. An (almost) straight line up and to the right—nothing wrong with that.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

The danger of looking at long-term logarithmic charts is that the true experience of the investor is cloaked by the big picture view. Hindsight returns over long periods of time are great, but real investors live in the moment. They panic when their portfolios lose money and get overconfident when things are going well.

Instead of steadily higher returns as the long-term chart above suggests, investors experience many drawdowns in the 5-10 percent range and several that are much deeper still. Being an investor, including a buy-and-hold indexer means being in some level of drawdown much of the time.

Here is the same 60/40 portfolio plotting the drawdowns during this time period.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

The drawdowns of a 60/40 portfolio are severe enough to shake the confidence of most investors. The intensity only increases when investors slide up to 80 or 90 percent equities for better returns.

The Danger of Overlooking Bonds

Many investors have a profound misunderstanding of bonds in their portfolio. Quality bonds are easily dismissed as a drag on returns, a portfolio afterthought, or even old fashioned. (I admit I had some of the same reservations about bonds for a time.)

However, I've come to view bonds differently in the past few years. The way I see it, money invested in bonds is the money you have; money invested in stocks is the money you are willing to lose in order to obtain potentially large returns.

With this logic, bonds should be the core of a portfolio for most investors, not an afterthought. The more bonds an investor has in their portfolio the better they will sleep, the more stable their portfolio will be, and the more cash access they have available for daily spending without sacrificing the return drivers in their portfolio. Further, it is reckless to risk potentially catastrophic losses with high percentages of your money.

We quickly see that the standard 60/40 (or more aggressive) portfolio falls short of adequate stability. With a small portfolio allocation in bonds, it can be difficult to take money out of the bond side for daily expenses without adding too much risk into the portfolio. If we take money from the stock side, we are effectively cutting down the money tree.

For example, lets say an investor has a $1 million portfolio and needs $50,000 to buy a new car. If they only hold 10 percent bonds, they are effectively taking away half of their safe stuff. With 20 percent bonds, it would be a quarter. That could significantly reduce the stable portfolios of the portfolio and the ability to re-balance into stocks.

Bonds are likely to provide a moderate return over inflation over time. No one gets rich investing in quality bonds. Stocks can return 50 percent or more in a single year, but we know that even diversified stocks are prone to frequent drawdowns of 30 percent or higher. Major markets around the world, including the United States, have seen drawdowns exceeding 80 percent in equities.

To achieve a safe, stable portfolio that supports larger withdrawals, we need a lot of bonds. To achieve wealth building returns we need stocks.

The solution to this problem is a Leveraged Barbell Portfolio. With this approach, an investor can allocate the vast majority of their portfolio to quality bonds. A comparatively small amount of money can be allocated to highly leveraged stocks to achieve high overall portfolio returns.

Building a Barbell Portfolio Around Bonds

For the large bond holding, I believe the best option is to use short-term bonds. Shorter duration bond products are the least likely to lose value due to inflation or interest rate increases. Remember, the bond portion of the portfolio is for stability and moderate income.

There are a number of ways to properly access leveraged exposure to stocks for this style of portfolio. For most investors, the easy option is by purchasing highly liquid leveraged ETFs. There are a number of triple leveraged ETFs listed on U.S. exchanges. Some popular options are UPRO and SPXL (Large Caps), TNA and URTY (Small Caps), TQQQ (NASDAQ), and EDC (Emerging Markets).

Another option is buying deep in-the-money call options on the largest standard ETFs. To get the necessary exposure with call options, an investor could choose LEAPS options on SPY (Large Caps), IWM (Small Caps), EFA (International Developed), EEM (Emerging Markets), or QQQ (NASDAQ).

It is important to only use leveraged ETFs or call options to utilize leverage for this strategy. With both of these instruments it is impossible to lose more money than you allocate to equities. A call option might become worthless and a leveraged ETF might become worth nearly nothing, but they won't go into negative value. You can only lose what you put into the instrument.

This is unlike using margin to buy ETFs or buying indices with futures contracts. With margin and futures you can lose more than you allocate to the equities because your bond allocation will be used to secure the margin. A stop-loss would help, but will not have the same effect or ease of management.

Comparing Returns to a Bond-Based Portfolio

The chart above showed the returns of a standard 60/40 portfolio since 1950. (For data purposes I used T-bills instead of bonds in all charts.) An investor using triple leveraged ETFs would only need to have 12.5 percent of their portfolio in leveraged stocks to achieve similar annual returns to a 60/40 portfolio over the past seven decades.

Here's the comparison chart.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

On the surface, both charts look very similar. Two nice lines traveling steadily up and to the right. However, with a tiny 12.5 percent allocation to risky assets, the leveraged barbell portfolio has a much different characteristic in drawdowns.

Sources: TheRichMoose.com, S&P, FRED-Federal Reserve St. Louis

In nearly all of the drawdown periods, the Leveraged Barbell Portfolio experienced drawdowns that are approximately half the severity of the standard 60/40 portfolio. Many were less than half.

Only in the 1987 crash, which saw a massive one-day fall that most affects a daily leveraged product, did the Leveraged Barbell Portfolio experience a drawdown that is comparable to the standard 60/40 portfolio. Still, the portfolio never lost more than the amount of risk assets it held at the peak before the crash.

A Leveraged Barbell Portfolio can provide superior risk-adjusted returns. With more than 80 percent of the portfolio in quality bonds at any given time, the portfolio spins off interest income and provides easy access to large amounts of cash without distorting the risk profile or taking away from potential returns.

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Developments in Cryptocurrency

As many speculators keeping an eye on the space know, cryptocurrencies as a whole got absolutely hammered in 2018. This event was quite predictable given the mania that occurred in 2017 and early 2018. Everyone who asked me about cryptos at that time got a firm answer, "Stay away!"

Electronic tokens trading at valuations of billions of dollars when no-one even knows what to do with them is crazy! Sure, sending money around the world quickly and at a low cost is fantastic, but anyone with an ounce of honesty knew they weren't buying cryptos for that.

What Happened in 2018?

A lot of people who jumped into the space to buy Bitcoin and other "alt-coins" in 2017 have learned a hard lesson in speculation. Many have lost 80 to 90 percent of their money last year. Others got ripped off by exchange hacks, poor security, and scammers or lost access to their wallets.

However, 2018 was actually a great year in the blockchain world as far as the technology goes. This past year we are seeing better development of smart contracts, higher transaction capacity within the various protocols, increased efficiency, and some interesting end-user emerging projects.

For example, artists may soon be able to load their creative work on blockchain platforms and receive micropayments for each "listen" or "view" directly from their consumer. Code can be embedded into the work to prevent loss of revenue from things like torrent uploads.

Websites and blogs could attach micropayments to articles so readers can show appreciation for the work done by the authors. While many would shy away from a $10 monthly subscription (a general minimum amount required to make a credit card transaction viable), paying something like 1/10th of a penny to read an article might be acceptable.

There are also some very interesting advancements using blockchain contracts for betting. One project, Augur, is establishing an open-source market for bets. While not yet fully active, the idea is that users will be able to freely design bets of all kinds and settle in cryptocurrencies in a peer-to-peer format.

Beyond gambling on horseracing or election wins, Augur could theoretically host bets that work like options contracts or futures contracts in financial markets. It would completely bypass the exchanges, drastically reduce fees, and eliminate third-party risks as we saw with MF Global and some of the FOREX brokers.

One of the most exciting changes is the continued development of transaction processing and verification. As you might know with Bitcoin, the proof-of-work ("mining") model is very energy intensive. It also limits the number of transactions the system can handle to less than 10 per second.

Cardano, TRON, IOTA, and a few other projects are basing their verification and transaction handling process on proof-of-stake protocols. They claim this will allow great decentralization, be highly secure, and the blockchain will be able to handle hundreds of transactions per second with a roadmap to increase this to thousands of transactions per second.

The second largest blockchain platform, Ethereum, is said to be moving to a proof-of-stake protocol as well in the coming year so they can increase their transaction capacity and reduce the energy intensive "mining" process.

These developments are showing a use case for blockchain and cryptocurrencies that can be understood by the broader public. The blockchain is becoming more user friendly and it's only a matter of time before average Internet users will be able to use the blockchain for a wide variety of tasks.

It could be compared in many ways to the Internet: developing from a technical network used by universities and defense contractors to today's user friendly tools like Google, WordPress, and Interactive Brokers.

I suspect we might be at the beginning stages of a very exciting time in the blockchain world. If even a fraction of the blockchain ideas proceed, it will be a major disrupter to today's giant "middlemen" corporations: banks, exchanges, lawyers, payment processing companies, data management companies, and so on.

Speculating in Blockchain/Cryptocurrencies

From a technical trading perspective, a number of cryptocurrencies are beginning to look much more attractive. I'm particularly interested in the cryptos which are making large strides in technology—often called the 3rd generation blockchain.


Source: Yahoo Finance

While technically still a second generation blockchain project, Ethereum started the idea of smart contracts and has an active developer community working on moving the blockchain into the third generation to compete with Cardano and TRON.

After bumping up against the 10-week simple moving average for most of 2018, Ethereum solidly crossed over and has been climbing upwards for the past three weeks. The crypto also hit long-term oversold conditions in December 2018.


Source: Yahoo Finance

Cardano is solidly a third generation blockchain with ample academic research behind it. The developers are working hard perfecting proof-of-stake models and are making significant progress in other areas of the protocol as well.

This is a newer blockchain that is still in early stages of development. However, it is also one of the most interesting projects in the entire space. If even a portion of their objectives are achieved, Cardano could be a blockchain platform that is a true game changer.

Cardano features a similar technical picture as Ethereum. The last several weeks have seen a turnaround that could be very promising for speculators.


Source: Yahoo Finance

TRON was formerly a token issued under the Ethereum blockchain. A migration to an independent third generation blockchain took place in June 2018. TRON has focused their efforts on the entertainment industry.

TRON is a Chinese-based blockchain group with many developers who formerly worked at companies like Tencent, Baidu, and Alibaba. The team seems highly centered around the CEO Justin Sun. TRON does state it is a fully decentralized blockchain which is a not-for-profit.


While still highly speculative and risky for any individual investor, cryptocurrencies seem to have finally shaken off the mania of the past several years. Interesting things are happening in this space.

Using simple trend indicators, some of the better cryptocurrencies are making a shift from a long, solid downtrend to a potentially promising uptrend. This could be a good time to take a closer look at some of these currencies and add a tiny amount to your portfolio.

I think it's still fair to say that many of these blockchain projects will fail and their associated currencies will be worthless. Proper risk management is absolutely crucial in this space as it is in all investing applications.

Some of the most interesting blockchain projects in my view are Cardano, TRON, and Ethereum. As these projects continue to develop their capacity and end-user tools, their adoption could become much more widespread. That can only mean one thing for their associated currency valuations.

Comments & Questions

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