A barbell is very heavy at the extremes, and light in the middle. The center of mass, or average mass, gives a very bad summary of a barbell. Its center of mass is in the middle of the bar. But if you plot mass a function of x, M(x), you get a bimodal distribution:
Stock market portfolio
When I first learned investing, my teachers recommended a specific asset mix. It went something like this: 3 months living expenses for emergencies (maybe 5% of my savings at the time), with the remainder (95%) in stocks. The 3 months living expenses protects me in case of total disaster (simultaneous loss of job + crash of stock market). For additional safety, the stocks were diversified in different classes. And within each class I would have dozens or hundreds of different stocks for further diversification.
Different classes included growth vs. income vs. emerging markets or some garbage like that. I can’t even remember those categories now because they are nonsensical. These categories perpetuate the myth that stocks are different. In fact the really big stock market moves, big crashes like 1987 or 2008, tend to hit every stock at once. The safety from diversification is an illusion.
Another problem with publicly traded stocks is that those companies are already huge. Their potential for growth is very small. Sure, some companies are bigger than others. But any company that you can buy from your broker is already public. None of them have the potential for 10x, 100x, even 1000x gains. So, public stocks have the potential for sudden crashes, without the potential for sudden massive jumps in value.
Barbell: Safety first
Barbell portfolios are composed of extremes. One portion is very safe, the other is very risky. If you know 90% of your liquid savings are safe then you will sleep well at night regardless of what the markets are doing. If 10% is used to speculate on extremely volatile assets then you still have a chance for tremendous gains. It’s the closest thing to having your cake and eating it too.
This diagram shows the two extremes of a barbell portfolio. The first is the safe extreme (left panel). By keeping 90% of my assets in cash, very short-term Treasuries, and precious metals I am protected from inflation. This includes protection from the very unlikely but very disastrous possibility of hyperinflation–a complete collapse of USD. I sleep well at night. The distribution is tightly peaked about 0.9, the initial investment.
Because of this safe portion, I don’t check the markets continuously. If I want to spend a few weeks oblivious to the markets then I can do that without worry.
Barbell: Risk and reward
The risky extreme (right panel) has a more unusual shape. Say at any given moment your risky asset has an equal probability to move up or down in value. Assume also that the distribution of possible moves is symmetric about zero. Even with these assumptions, your expected return from that asset is not zero. The value can become zero, but it will never be negative. At worst you lose all the money you invested in that asset. But at best the value doubles, triples, even increases by 10- or 100-fold. While this property is also true of stocks (and anything you own), it is more important for volatile assets. Publicly traded stocks are unlikely to fluctuate to 0x or 10x, but very volatile assets, such as startups, might. In that case the underlying asymmetry of equity becomes important.
Note that shorting stocks or other assets has the opposite property. When you short an asset, your potential gain is truncated at the value of your investment. But your potential loss is unbounded below. That’s one reason I never short anything and avoid leverage of any kind.
Back to the diagram: because of this strange property of volatile assets, the distribution is asymmetric in my favor. It is not gaussian. It has a long, fat tail reaching to higher returns.
Combined barbell portfolio
So, by wild speculation with 10% of my assets I still have a chance for massive gains. At worst I lose 10% while keeping the 90% in the safe side of the barbell. (Compare that with a 50% drop in the stock market for the person entirely in stocks. They lose 50% of their net worth.) At best…well there is no upper-bound. This is the whole point of the barbell: bounded losses below, unbounded gains above. I truncate my loss at 10% while the theoretical gain is unlimited. If my 10% investment grows ten-fold then I’ve nearly doubled my net worth. If it grows 100-fold then my net worth has grown by 10x. The combined distribution looks something like this:
Notice the long tail to very high values. This is a subtle point: even though the probability of a huge gain looks small in the diagram…but the expectation is not small. Probability does not include the payoff. But the expectation does:
expectation = return X probability.
If the return is massive, e.g., 10x, 100x, or more then even a very small probability can generate a huge return in the long run.
The challenge here is in choosing the speculative portion of the investment. What can you put your money in that has a shot at increasing 10x or 100x? Not lottery tickets! Startup businesses is one example. Although most fail, the few that make it can easily generate 10x or higher returns. But most startups are only open to accredited investors. (Thanks SEC!) If you have less than $1 million in liquid assets it is harder. More on this another time.
I’m not an investment or financial advisor. This is not investment advice. Make your own decisions and always study carefully before putting your money anywhere.