This is the first in a series of articles on what I’m referring to as ‘alternative finance.’ This is not to be confused with DeFi or next-generation finance, rather, it’s alternative in the sense of falling outside mainstream, conventional Wall Street thinking. The markets are entering new territories, and old models often don’t hold up in practice. In this series — however long it ends up being — you’ll be introduced to some ways of thinking about investing, trading, and portfolio management that you perhaps haven’t heard before. Are these strategies right for you personally? That’s for you to decide in consultation with your advisors.
DISCLAIMER: This article is provided solely for informational purposes and should not be construed as personalized investment, trading, or financial advice. I make no representations or warranties of any kind as to any of its content or the accuracy thereof. All investments carry risk, and you should consult with your financial advisor, accountant, and/or attorney prior to making any investment or trading decisions.
Modern Portfolio Theory
Much of conventional asset allocation in the securities markets revolves around a concept called Modern Portfolio Theory. The idea is that by balancing your portfolio with proper weighting and diversification, you can mathematically gauge how much risk you are assuming relative to how much return. Leveraging this theory, conventional asset management attempts to construct portfolios based around broad-bucket investor goals (e.g., aggressive growth, balance, safety of principal, income) and time horizon (how long until they expect to withdraw or liquidate the asset). Using the principles of Modern Portfolio Theory, along with client risk tolerance, time horizon, and other related factors, asset managers may attempt to construct an ‘optimal’ portfolio based on a risk/reward ratio that should, over time and averaged out, fulfill the client’s goals.
This thinking often works relatively well when things are ‘normal’ and client goals are modest, but it typically doesn’t function well during the abnormal. Most of these models are not equipped to handle scenarios where the market might go down -50% or more, or enter a prolonged depression, or deal with either hyper-inflationary or hyper-deflationary environments. Even if the model could mathematically cope with these things (itself a very dubious proposition), it can’t account for the human element: most people, during times of market crisis, will run for the door, thus feeding into the sell-spiral. Few are willing to sit through massive losses waiting potentially years or even decades to make their capital back. The psychological element is often the greatest hurdle in successful investing and trading.
These types of conventional models rely on playing the middle. They are a blend of a little aggressive, a little conservative, and a lot of middle ground (in mostly U.S.-based assets). This is why a lot of people have been trained to think that it’s reasonable to risk 100% of their capital in things like mutual funds, index fund ETFs, and bonds in exchange for an annualized average return of, say, 8%. Essentially this means risking $100,000 to make an average of $8,000 over the course of a year. Some years may be more and some less, but assume this is an annualized average. And this introduces us to our first concept: asymmetric positions.
Symmetric positioning would be risking $1 for the chance to make $1. Almost all positions are asymmetric, though the difference is in degree. Risking $1 for a chance to make $1.10 would be mildly positively-asymmetric. Risking $1 for a chance to make $0.90 cents is mildly negatively-asymmetric. However, most of the the conventional models are extremely negatively-asymmetric: in the example above, the investor is risking $1 for a chance to make $.08 cents.
Many of history’s greatest investors and traders do the opposite: they seek out extremely positive-asymmetric positions. They may risk $1, but the upside might be $10, $50, or even $100. Risk of 100% loss may not sound too great when the likely upside is around 8%, but risking 100% loss to potentially make 1,000% is an attractive proposition.
Does this mean that it’s a good idea to rush out and put all assets into a bunch of highly-speculative, risky investments? NO. All of those assets could still go to 0, leading to a complete or near-complete wipe out. We’ll talk about the importance of position sizing in a future article, but for now, we’ll discuss just one potential method that seeks to capitalize on extremely positively-asymmetric positions: the Barbell Strategy.
Popularized by trader and philosopher Nassim Taleb, and built upon premises from the Roman philosopher Seneca, the Barbell Strategy does the opposite of playing the middle ground; it lives entirely in the extremes. According to barbell thinking, the middle ground is where most problems happen because it’s impossible for anyone to perfectly predict the future, and also because abnormal times do come. So instead of investing in the middle, barbell investors are both hyper-conservative and hyper-speculative simultaneously (visualize a barbell and you can get a sense of the meaning: the weight is concentrated on the two extremes).
On the conservative side, the investor uses only extremely ‘safe’ assets. What constitutes safety is also semi-relative and up for debate, but these would generally consist of things that tend to roughly hold their value or even slowly appreciate over time, or at least not experience massive downturns like other asset classes: cash in a savings account or bank Certificates of Deposit across a basket of ‘stable’ currencies, precious metals (particularly gold), unleveraged (read: not mortgaged) real estate located in a stable and growing area, productive farmland, jewelry, etc. This portion of the portfolio is intended to be the vast majority; a typical number is 90% of assets, but it could be lower (such as 80%, 70% or even less) depending on the individual investor’s preference. The point is this part of the portfolio is intended for preservation, where notable risks are not taken, and thus the chance of wipe out is extremely low. Of course, such assets also must be stored safely or insured properly if they are to be relied on for capital preservation. It does no good to protect yourself from market losses only to have a natural disaster, fire, or burglar wipe out your capital.
On the speculative side, the investor takes extremely risky positions where the chance of 100% loss is not only possible, it’s perhaps even probable. However, the upside is immense: it might be 10x, 100x, or even 1,000x or more depending on individual performance. What kind of assets might go here? Typically things like high-potential derivatives (such as far out-of-money options contracts), angel or venture capital investments in startups, penny stocks, cryptocurrency ICO’s, or even starting your own business. Basically, anything where the risk of total loss is high, but the potential upside is massive. The idea is that most of these investments will probably be losers, but even one or two grand slams have the potential to wipe out all losses and still generate a massive return. Note: this is essentially the model used by most venture capital firms. They invest in many promising startups knowing that most will fail, but that a small handful of winners is enough to make up for all the losers and still profit.
Top investors still need to exercise fervent due diligence in this part of their portfolio; it’s not about just randomly picking risky assets. If this part of the portfolio is filled with a bunch of high-potential, but low quality assets, they might all go to 0, which isn’t desirable. Due diligence is needed to improve the chances of getting a big return.
Does the Barbell Strategy work? No strategy is ever guaranteed, but barbell investing has worked for many top investors. The first benefit is the risk of wipe out is extremely low,because most assets are held in conservative positions. Even if there’s a total market crash and Great Depression 2.0, many or most of the barbell investor’s assets (assuming they have properly diversified) will likely be safe. The #1 rule of successful investing is don’t get wiped out, and the Barbell Strategy tends to be an effective way of accomplishing that.
But the second benefit is there is still potential for massive upside.The speculative portion of the portfolio might go to 0, but it also might lead to huge returns. Thus, the Barbell Strategy, when properly and diligently executed, may offer the best of both worlds: strong asset protection with the potential for extreme positively-asymmetric returns.
ALTERNATIVE FINANCE SERIES
Part 2: In Defense of Short Selling (and Why You Probably Shouldn’t Do It)