Return on investment indicates how much your money will earn for you. Return of investment should be our primary concern followed only by return on investment. There isn’t a return on capital if there is no return of capital.
Pick Your Own Investment Return
Return on investment can be classified as high, medium, or low. We all want a high return on investment. You can pick your own level of return.
But the flip side is you are picking your risk level also. We need to understand that the only way to boost returns is to take on more risk. Risk and return are inextricably linked.
How should we invest our money?
My Mentor on Risk
NN Taleb gave me some personal investment advice. He recommended I “stop trading.” He contends that there is more risk in the financial market than the average investor realizes.
He felt I had enough money to provide a comfortable life. If I continue to put my money at risk in stocks then I could lose enough to reduce my quality of life.
I might be forced to work more than I want. Since this brilliant mathematical philosopher’s net worth is north of the stratosphere, I took his advice to heart. I stopped putting most of my money at risk.
Barbell Investment Strategy
I first learned of the barbell strategy from N.N. Taleb. Taleb is a brilliant thinker, author, and investor. He has a background in philosophy, mathematics (Ph.D.), business (MBA), and derivatives trading. In his best-selling books ( The Black Swan, Antifragile, and Fooled by Randomness), he dishes out practical advice on thinking, life, and investing.
Here is how he lays out the issue of risk in investing: “If you know that you are vulnerable to prediction errors, and […] accept that most “risk measures” are flawed, then your strategy is to be as hyper-conservative and hyper-aggressive as you can be instead of being mildly aggressive or conservative.”
When I think of a barbell I think of a metal rod with two equal weights. It is symmetric.
That is not what we are talking about here. Maybe it should be called bimodal. Nevertheless, the barbell name has stuck.
Practically this may mean keeping 85% to 90% of your investable funds in short-term Treasury securities or cash and 10% to 15% in speculative, high-risk investing like hedge funds, VC projects, start-ups, options on gold, or angel investing.
Manage Your Risk
Tim Ferriss invests this way by having a portion of his money in high-tech Silicon Valley start-ups. The rest is conservatively invested.
Michael Murphy of the New World Investors also recommends the barbell approach. Unlike Taleb, he considers undervalued, high-dividend-yielding blue chips to be safe. NN Taleb disagrees, pointing to unknowable market risk in stocks that are traded.
Truly Safe Investments
The barbell way of thinking can be applied to bonds. You could invest almost all your fixed-income assets in short-term instruments like U.S. T-bills. Then invest the remaining 10% or so into “junk-bonds” or long-duration corporate bonds.
Hidden Risks of the Dangerous Middle
The key is having no investments in the “middle.” That would be the market where many of you are now invested. You think it is relatively safe, but the smart and experienced do not agree with you.
NN Taleb looks at risk as upside and downside. If you have most assets in the “safe” bucket, then a crash will not harm you. If you have some assets in the “speculative” bucket, then you have unlimited upside potential.
Chance of Wipeout
As an example, let’s say you have two investment options: one is high-risk and likely to pay a 33% return. Don’t laugh, those investments are out there. A lower risk option returns 5%.
How would you allocate your funds? Since 33% is an outstanding return, you could put the bulk of your money there – but there is a significant chance that you could get nearly completely wiped out.
If you chose only the 5% option, you would not grow your wealth. If you put 85% in the low-risk and 15% in the high-risk option, there is almost no chance of a total or even significant loss.
And yet your return would be quite healthy: 85% of 5% + 15% of 33% = 9.2% return. Not bad for a portfolio that is 85% safe!
Stop Playing When You Won
The barbell portfolio works very well. It allows some growth but avoids catastrophic loss. Another wealthy genius who has given me advice is Dr. Bill Bernstein.
He too counsels that once you made “enough,” stop putting money at risk. Why stretch for a higher return that won’t benefit you. It only puts your needs and lifestyle at risk. This is brilliant advice.
High Returns are Enticing
But still, the siren song of the financial markets call to me. I have made an enormous amount of money investing in individual stocks, mutual funds, and ETFs.
I acknowledge that there are inherent risks that I don’t understand. But, I also don’t like it when I’m not benefiting from the overall growth of the American businesses.
I can’t seem to block out all the financial news. I want a piece of the action. Also, I am not as connected or as bright as Drs. Taleb or Bernstein. My high-risk part of the dumbbell isn’t likely to pay off the way theirs might. Sometimes I feel like I’m the dumbbell in this portfolio method!
Most investment advisors recommend we invest heavily in stocks. The long-term stock market performance record is indeed excellent. Assuming we don’t panic and sell at the wrong time. By saving regularly and investing in stocks, building wealth can be simple.
Bonds can help produce income and reduce volatility. Unfortunately, current bond returns are low and unsatisfying.
Three Floors of Risk
So, what’s a modern investor to do? Well, I’m not sure what you should do. But I will tell you what I do. I think in terms of three layers of investing. Let’s build a three-story house.
First Floor – The Secure Base
The first floor is the low-return floor. It is the secure base. It won’t grow much, but it won’t crash by 40% either.
This reduces the volatility of your overall portfolio. It also could provide funds in a bear market.
That way you won’t have to sell a lot of shares at a loss to provide liquidity. This category can include money market funds, T-bills, CDs, high-grade short-term corporate and government bonds, TIPS, GNMA funds, and good old-fashioned cash.
The goal here is safety, not large return and growth. Maintain and maybe go up a few percents per year. For me, this is 40% of my total investable assets.
If the two top floors crash down or are in temporary disrepair I could live on this main floor for many years.
Second Floor – Market Return
The second floor is the medium return floor. It is the market. This may return 8-10% on long-term averages but could be up 35% or down 70% in any given year.
The engine of the US economy is captured here as are multinational companies. This could be large dividend-producing stocks, S&P 500 index fund/ETF, foreign equities, etc. This medium risk (in the long term) floor accounts for 40% of my funds.
Third Floor – High Investment Returns
The top floor is the third floor and it is high return. This is a lot riskier than the market. In fact, one must be an insider, entrepreneur, business owner, and/or accredited investor to even have access to many of these.
This could include hospital ownership, your own company, small business angel investing, leveraged real estate, surgery centers, senior living facility investments, buying stock on margin, derivatives, etc.
These tend to be speculative. The risk of loss is real. On the other hand, returns of 25%-40% are routine. Currently, this accounts for 20% of my investments. I usually call it “other.”
I currently invest in a 40/40/20 model with bonds/stocks/other representing those categories. It has worked well for me.
Stability is always present on the first floor.
Growth comes from the second and third floor.
So far, my house is accommodating and solid enough in its construction to withstand a financial shock. How about yours? Do you risk-stratify your investment return?
For more insight into this risk-stratification model, check out the Aspirational Investor.