The short version
- The barbell strategy a way to invest in safer and more speculative investments, or long-and short-term bonds, to maximize profit and mitigate risk.
- You can apply this strategy to bonds, mutual funds, and stocks — or just about any investment you can think of.
- This active investment strategy involves reviewing your portfolio and making adjustments on a regular basis.
What is the barbell strategy?
There are a few different ways to implement the barbell strategy, but one of the most common is to invest a large portion of your portfolio in very safe investments, such as government bonds, and then to invest a smaller portion in much riskier assets, such as growth stocks. Doing this minimizes your chances of losing money if one of your risky investments goes bad while allowing you to make some money if one of your risky investments pays off.
The barbell strategy avoids medium-risk investments and medium-term bonds. Medium-risk investments can be more volatile than low-risk or high-risk investments, making them more challenging to predict and manage. Additionally, medium-risk investments may not offer the potential for higher returns than low- or high-risk investments do. And when it comes to bonds, short-term or long-term bonds are better for reasons we'll get into below.
More: What are growth stocks and how are they different from value stocks?
How does the barbell strategy work for bonds?
While the barbell strategy can be used for securities, most investors use it for bonds. The overall bond market is typically broken down into three main segments: short-term, medium-term, and long-term bonds. Here's how the SEC defines each:
- Short-term bonds: Have a maturity date of few than 3 years
- Medium-term bonds: Have a maturity date of 4-10 years
- Long-term bonds: Have a maturity date of 10+ years
Bonds are typically negatively correlated with interest rates: When interest rates go up, bond prices usually go down. However, short-term bonds tend to be less sensitive to interest rate fluctuations than longer-term bonds. Here's why.
Investors only have to wait at maximum 3 years for their short-term bonds to mature, at which point they can reinvest the money in a new short-term bond at the current rate. But due to their far-out maturity dates, the prices of long-term bonds tend to be more affected by changing rates.
But while short-term bonds are less sensitive to interest rate movements, they also tend to pay lower yields (all things being equal). So while long-term bonds represent a higher interest-rate risk in the short-term, they also tend to provide higher returns over the long haul. Medium-term bonds are right in the middle of both of these extremes and strike a balance of interest rate risk and overall yield.
With the barbell strategy, investors gain exposure to both short-term bonds (safest/lowest yield) and long-term bonds (riskiest/highest yield) and ignore medium-term bonds altogether. This is an active management strategy which means that you’ll need to constantly monitor your portfolio and the prevailing interest rates.
More: How to invest in bons: diversify your portfolio
What are the benefits and drawbacks of the barbell strategy for bonds?
- Better performance –This strategy gives investors access to higher-yield long-term bonds while offsetting some risks, hopefully resulting in better overall portfolio performance.
- Less risk –This strategy lowers the risk because short-term bonds and long-term bonds tend to have negatively correlated returns (which means that when short-term bond yields rise, long-term bond yields tend to drop)
- Sensitive to interest rates — While the barbell strategy aims to mitigate the risks associated with fluctuating interest rates, interest rates are still a significant risk to this strategy. For example, if you purchase long-term bonds with very low interest rates, those bonds will lose value as interest rates increase.
- No medium-term bonds — A second risk is the lack of exposure to intermediate-term bonds. Generally speaking, medium-term bonds have better returns than short-term bonds, with only a small amount of additional risk. By forgoing intermediate-term bonds, you might be losing out on potential returns.
How does the barbell strategy work for stocks?
The name of the game with barbell strategy is to choose both high-risk and low-risk assets. By buying assets at the extreme ends of the spectrum, you hope to balance the assets and bolster your portfolio during both good times and bad.
While this strategy is mainly used for bonds, you can also use the barbell strategy for buying stocks. To use the barbell strategy with stocks, you might purchase small-cap and large-cap stocks, while ignoring those in the medium-cap category. Or you might buy income stocks and growth stocks while leaving out value stocks.
More: Growth stock vs. value stocks
What are the benefits and drawbacks of the barbell strategy for stocks?
- Mitigate risk – Since you are investing in both high- and low-risk investments, you limit your overall risk by diversifying your portfolio.
- High potential returns – By investing in higher-risk investments, you have the potential to earn higher returns on your investments.
- Flexibility – Depending on market conditions and risk tolerance, you can adjust your investment mix as needed.
- Limited diversification – Although the barbell strategy can help you spread out your investments, it does not provide broad portfolio diversification.
- Volatility – Higher-risk investments can be very volatile, making it difficult to predict their performance in the long run.
- Timing – To get the most out of your barbell strategy, you must be able to predict market movements accurately. This can be difficult for inexperienced investors (and for experienced ones too!).
- Potentially Higher Taxes – Depending on the types of investments you choose and how often you trade them, you may pay more taxes than passive investment strategies.
Should you use the barbell strategy?
Is the barbell strategy a good choice for you? That depends on several factors. One factor is the yield curve. The yield curve is a graphic representation of the interest rates for a range of bond maturities.
In general, when the yield curve is “normal” or up-sloped it usually indicates a healthy economic climate with strong growth prospects. It represents a normal relationship between interest rates and the length of the bond maturity (long-term bonds are riskier and tend to have higher yields).
This yield curve doesn’t always take that shape, however. For example, when the yield curve is “inverted” or flattened, it often signals an upcoming recession. In this case, short-term bond yields will be higher than long-term yields.
Some proponents of the barbell strategy say that the best time to use it is when the curve flattens as this when there's the least difference between short-term and long-term bond yields. In a flat yield curve, investors can reinvest the proceeds from a maturing short-term bond into new bonds with faster-growing yields.
As you may have noticed, the barbell strategy is very hands-on. If you want to pursue this strategy, you’ll need to monitor your investments regularly and reinvest your bonds when they reach maturity. If you are more of a “set it and forget it” type of investor, the barbell strategy may not be suitable for you.
More: Which passive investment strategy is right for you?
The bottom line
The barbell strategy offers a way to balance risky investments with safer choices, especially in regard to bond investing. Investing in bonds has always been an excellent way to help smooth out the fluctuations of the stock market and the barbell strategy can help you maximize your bond returns.
Whether you apply the strategy to your portfolio of bonds, stocks, or both, it's ideally suited to experienced investors because it requires regular monitoring and reinvestment. If you feel passive investing is more your style, some alternatives to the barbell strategy include investing in mutual funds, index funds, and exchange-traded funds (ETFs).
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