In 1987, Nassim Nicholas Taleb was a trader on Wall Street. But unlike most of his peers, Taleb wasn’t pinning his hopes on a market rally. Instead, he had positioned himself to benefit from a market meltdown. On October 19 of that year, just such an event occurred. For no apparent reason—in the midst of an otherwise strong market—the S&P 500 dropped 23% in just one day. The result: Taleb made a fortune—enough to retire at age 27.
How did he do it? The strategy Taleb used is known as a “barbell.” On one side, most of his portfolio was invested in extremely conservative government bonds. But on the other side, Taleb held a large number of option contracts. As its name suggests, an option is an agreement that gives an investor the option to buy or sell an investment at a particular price. A stock option, for example, might give an investor the right to buy a stock at $20 per share. In this case, the option would become valuable if the stock’s price rose above $20, because it would allow the option-holder to buy the stock for $20, then sell it for more.
In Taleb’s case, he held what are known as “out of the money” put options. This type of option gives an investor the ability to sell an investment at a price that is far below the current market price. Because such an option would have value only in the event of a sudden and severe market downturn—a relatively rare event—these options tend to be inexpensive. That allowed Taleb to load up on them at a very modest cost. But on that day in 1987, when the market dropped 23%, these options suddenly multiplied in value. Options that he’d purchased for a few cents were now selling for as much as $5. That was when Taleb was able to retire from Wall Street.
It’s because of stories like this that barbell investment strategies can seem attractive. As Taleb later described in his book The Black Swan, barbells allow investors to be simultaneously “hyperconservative and hyperaggressive” and to thereby protect themselves from—and even benefit from—unpredictable risks like the crash in 1987.
Much as it worked for Taleb, though, this sort of strategy entails a few challenges. First, it’s complicated. Buying options requires both expertise and constant vigilance. And because option contracts have expiration dates, an option can easily lose 100% of its value. The good news, though, is you don’t need complicated and risky strategies like this to benefit from a barbell. There are other, simpler ways to move in this direction.
The easiest approach might seem deceptively simple: If you own a combination of stocks and bonds in your portfolio, the result can be a very effective barbell. Over the past 10 years, the correlation between the S&P 500 and the bond market has been just 0.3 (on a scale where 0 represents no correlation and 1 represents perfect correlation). That’s just the average. In many years, the correlation between stocks and bonds has been negative, meaning that bonds have gained in value when stocks have dropped. We saw this between 2000 and 2002, when the market dropped three years in a row. We also saw it in 2008, when the stock market dropped 37%, and we saw it again when Covid hit in 2020.
A variation on this strategy would be to combine stocks with cash instead of with bonds. That can work, but because bonds have the ability to gain in value—and cash does not—bonds tend to be even more effective in a barbell.
That said, bonds can lose value. To guard against that, you might diversify your bond holdings. You could, for example, hold a mix of short-term and intermediate-term bonds. While intermediate bonds gain more when rates fall, short-term bonds hold their value better when rates rise. To further diversify this side of your portfolio, you could hold a mix of bond funds and individual bonds. However you structure it, the key is to make this side of the barbell as stable as possible.
Some people dislike barbell strategies because it means that part of their portfolio will, by design, be slower growing. That concern is understandable. To help overcome this concern, I suggest looking at bonds through a different lens: View them as insurance rather than as an investment. Bonds, in other words, aren’t there to make money. Instead, their role is to help your overall portfolio avoid losing money when the stock market is down. Just like a home or auto insurance policy, bonds carry a cost, but they deliver an important benefit.
Beyond bonds, there are other ways to employ the concept of a barbell. Suppose you’re deciding when to claim your Social Security benefit. For each year that you wait, between ages 62 and 70, Social Security will increase your monthly benefit. That’s the most commonly-cited reason for waiting. But there’s a barbell-related benefit too: Because you’ll be receiving the largest possible guaranteed check from the government, you can afford to take more risk with your portfolio. That’s what Taleb was referring to when he talked about a barbell enabling an investor to be simultaneously hyperconservative and hyperaggressive.
Along the same lines, you could opt to annuitize a portion of your savings. That would allow you to take more risk with the rest of your portfolio.
If you’re married, there’s another way you could use Social Security to help build a barbell: You could claim one benefit as late as possible, at age 70, and the other as early as possible, at 62. Strictly according to the calculator, this wouldn’t be optimal, but that overlooks the reality that none of us knows our own life expectancy. By claiming one benefit early, it can help to mitigate this risk. It’s another way to implement a barbell.
Barbells can be applied in other situations too. Suppose you’ve benefited from one of the market’s highflying stocks, like Apple, Amazon or Nvidia, to the point that it now accounts for an uncomfortably large slice of your portfolio. One way to diversify this risk would be to add something like an S&P 500 fund to your portfolio. That would only be partially effective, though, because that fund would include the stock where you’re already overweight, thus increasing your exposure.
A solution to this problem would be direct indexing, whereby you’d purchase each of the stocks in an index individually. That might sound unwieldy, but there are services that automate this process. These services allow investors to tailor their portfolios in ways that aren’t possible with traditional index funds. In this case, you’d exclude the one stock you happen to already own so you could, for example, buy just 499 of the 500 stocks in the S&P 500. That would be another effective barbell.
