Tag: Fixed income

  • The Barbell Portfolio – Strategy Of A Balance

    The Barbell Portfolio – Strategy Of A Balance

    The Barbell Portfolio - Strategy Of A Balance
    The barbell portfolio holds only short term and long term bonds and generates fixed income. A flattening yield curve situation is the best time to use this strategy, while a steepening curve is harmful to the strategy.

    The barbell portfolio was invented by bond traders. The strategy means to hold safe short-term bonds and riskier long-term bonds. Put them together and that is the barbell portfolio. This also means that you are betting on both sides. But your barbell portfolio gives you protection since you have extremely safe short-term bonds. Yes, they will provide you with less profit but the profit is compensated from the other side of your portfolio – by long-term bonds that are extremely risky but provides a great profit.

    Building a barbell portfolio, you will give your investments a balance that can run you through different circumstances, even extreme ones. The barbell portfolio is a very simple investment allocation actually. But the barbell portfolio is heavily weighted on two ends, just like a barbell. This concept is easy to understand and we want to explain it by using bonds. You can create this kind of portfolio with cash and stocks, also it can be a nice substitute to a 60/40 stock/bond portfolio.

    How to structure barbell portfolio 

    Let’s say the short-term bonds are risk-free. But you will not earn a lot by holding only them. To have a profit you must add something riskier to your portfolio. So, you can do it by holding long-term bonds. You see we are not considering mid-term bonds. There are long-term bonds to provide the yield to your portfolio. 

    Yes, they are the riskiest but also give the highest returns.

    The idea of this kind of portfolio is to bypass and avoid the risk on one side of the barbell portfolio and to do it as much as possible but to put more risks with long-term bonds.

    For every investor, the risks diversification is one of the most important parts. So how to do that with a barbell portfolio? For example, you can build it if one half of your portfolio is in bonds with 5 years maturities and the rest is in bonds with 15 years maturities. The point is to put weight on both ends of your portfolio. But it hasn’t to be equal weight. it can be turned in one direction or another. Of course, it depends on an investor’s vision and yield demands.

    You have to pay attention to the bond barbell strategy. It isn’t a passive strategy. You will need to monitor short-term bonds and adjust them frequently. Also, the other end with long-term bonds should be adjusted from time to time because of their maturities shorten. Some investors will just add new bonds to replace the existing.

    Barbell Investing

    It is all about aiming to balance risk in your investment portfolio. For example, if you put bonds on the left end of the barbell portfolio you might be faced with rising interest rates. So, the value of the bonds could decline. In order to balance the weight, you can replace them or part of them with, for example, with dividend-paying stocks, or some other ETFs. This left side has a great role. It has to protect your wealth so the savvy investor will always choose low-volatile and low-risk assets for the left end.

    The right side’s role in your barbell is to give you high profits. That is your financial goal. So you can add some aggressive stocks there instead of long-term bonds.

    The barbell strategy is actually a simple investment allocation. Two ends, two sides of your portfolio are designed like opposite ends. What you have to do is to allocate your capital between safe and aggressive sides. Some experts recommend holding 80% treasury bonds and 20% stocks.

    Some may ask why to diversify like this. Here is why. Let’s say you have invested 100% in different stocks. Yes, you have a diversified portfolio but you are, at the same time, 100% exposed to downside risk and you are at risk to lose all your capital invested.

    But if you build a barbell portfolio with 80% bonds and 20% stocks your downside risk can arise on your risky part of the portfolio. That is 20% of stocks. But the point is that the majority of your portfolio will be in safe investments. Moreover, bonds will give you interest too.

    Why use this strategy?

    Because it can lower risks for investors. At the same time, it can provide exposure to higher yield bonds. Higher yields will compensate for the higher interest risk rate. So that is the first benefit. This strategy allows investors to have access to higher yield long-term bonds. The other benefit is that this strategy reduces risks because the short-term and long-term bonds’ returns favor being negatively correlated. In other words, when short-term bonds are doing well, the long-term bonds will have difficulties. When you hold bonds with different maturities it is more likely to have less deadfall risk. Let’s say when interest rates grow, the short term bonds are rolled over and reinvested. Of course, at a higher interest rate.  That will compensate for the drop in the value of longer-term bonds. Opposite, when interest rates are lower, the value of the longer-term bonds will grow. Simple as that.

    But remember, it’s so important to manage the weight of both ends. And to do it actively. The contrary will never produce long-term returns. If you notice that the assets on one end of your barbell portfolio somehow look expensive you have to change it and balance by leaning toward less expensive assets on the other end. Well, if the prices are expensive on both ends, you will need to reduce overall portfolio risk.

    Is there any risk?

    Yes, interest rate risk no matter do you hold both long term and short term bonds. If you buy the long-term bonds while the interest rates are low they may lose value quickly when the interest rates increase.

    An additional risk of the barbell strategy comes from the investors’ limitation, this portfolio doesn’t include intermediate-term bonds so you will not have exposure to them. And we all know that intermediate-term bonds give better returns than short-term bonds. Yes, they are riskier but not too much. In comparison with long-term bonds, intermediate-term bonds will offer a bit lower returns. That is the downside of the barbell portfolio because you don’t have an opportunity to earn on these returns.

    Well, the main risk of the barbell strategy lies in the longer-term bonds. They are more volatile than their short-term bonds. As we said, you will lose if rates rise and you choose to sell them prior to their maturity date. If you keep the bonds until the maturity date, the fluctuations will not influence negatively.

    The worst scenario for the barbell is when long-term bond yields are rising faster than the yields on short-term bonds. That is the steepening yield curve. The bonds that make up the long end of the barbell drop in value. So, you may be forced to reinvest the profits of the lower end into low-yielding bonds, to balance the portfolio.

    But the flattening yield curve, if yields on shorter-term bonds rise faster than the yields on longer-term bonds you will earn. That is an advantageous part of the barbell strategy.

    Bottom line

    The benefits of the barbell investing strategy are numerous. Firstly, you will have a better diversification of your investments. Also, you will have more potential to reach higher yields with less risk. If interest rates are falling all you have to do is to reinvest at lower rates when the maturity date of that bond comes. In case the rates are rising, you will have the chance to reinvest the profits of the shorter-term securities at a higher rate. Since the short-term bonds mature frequently, that will provide you the liquidity and adaptability to solve emergencies.

  • What is Diversified Investment

    What is Diversified Investment

    2 min read

    What is Diversified Investment

    Nothing more represents the term diversified investment than proverb “Don’t put all your eggs in one basket.” Instead, invest in many baskets and hold a substantially diversified portfolio based on your long-term asset allocation strategy.

    A diversified investment is exactly that.

    A diversified investment represents a portfolio of various assets that earn the highest return for the smallest risk. This kind of portfolio has a mixture of stocks, fixed income, and commodities. These assets react differently to the same economic occasions and because of that, diversification works. With diversified funds, you can access financial markets while spreading your investments across several asset classes and geographic regions. In this way, you reduce the impact of market fluctuations while maintaining an attractive potential performance.

    In a diversified portfolio, the assets don’t match each other. When one rises, the other falls. It drops down overall risk because some asset classes will benefit, no matter what the economy does. They equalize any losses of the other assets. There is also less risk because it’s difficult the entire portfolio would be destroyed by any single event. A diversified portfolio is the best protection against a financial crisis.

    How does Diversification work?

    Stocks do well when the economy grows. Investors want the highest returns, so they bid up to the price of stocks. They are willing to accept a greater risk because they are optimistic about the future.

    Bonds do well when the economy slows.

    Investors are more interested in protecting their holdings. They are willing to accept lower returns for that reduction of risk.

    What is Diversified Investment 1
    The prices of commodities vary with supply and demand. Commodities include wheat, oil, and gold. For example, wheat prices would rise if there is a drought that limits supply. Oil prices would fall if there is additional supply. As a result, commodities don’t follow the phases of the business cycle as closely as stocks and bonds.

    Diversification typically has low correlations to, or do not move in lockstep with, more traditional asset classes. As such, their inclusion in an investment portfolio tends to result in lower overall volatility.  Because they have a wider universe in which to invest (public and private) and do not have some of the same investment constraints (can short and hedge), alternative investments have the potential for higher long-term performance than traditional investments.

    Investing in diversified funds can, therefore, be an effective tool to:

    • Seek growth in your savings with a medium-term outlook and moderate risk
    • Benefit from exposure to several markets (equity, bonds) that is adjusted to match current conditions in order to both take advantage of market rallies and cushion against the impact of declines
    • Manage your portfolio simply with access to turnkey management: the manager adjusts the make-up of your portfolio over time.

    Where can you execute the diversified portfolio?

    A diversified portfolio should contain securities from the following six asset classes.

    Stocks. Different sized companies should be included. Company size is measured by its market capitalization. Therefore, include small-cap, mid-cap, and large-cap in any portfolio.

    Fixed income. The safest are savings bonds. These are guaranteed by the government. Municipal bonds are also very safe. You can also buy short-term bond funds and money market funds that invest in these safe securities. Corporate bonds provide a higher return with greater risk. The highest returns and risk come with junk bonds.

    Foreign stocks. These include companies from both developed and emerging markets. You can achieve greater diversification if you invest overseas. International investments can generate a higher return because emerging markets countries are growing faster. But they are riskier investments because these countries have fewer central bank safeguards in place, can be susceptible to political changes, and are less transparent.

    Foreign fixed income. These include both corporate and government issues. They provide protection from a currency decline. They are safer than foreign stocks.

    Commodities. This includes natural resources such as gold, oil, and real estate. Gold should be a part of any diversified investment because it’s the best hedge against a stock market crash. Research shows that gold prices rise dramatically for 15 days after the crash. This is why people invest in gold. Gold can be a good defense against inflation. It is also not correlated to assets such as stocks and bonds.

    Maybe you should include the equity in your home in your diversification strategy.

    If your equity goes up, you can sell other real estate investments in your portfolio. You might also consider to sell your home, take some profits, and move into a smaller house.
    What is Diversified Investment 2
    Most investment advisors don’t count the equity in your home as a real estate investment. They assume you will live there to the end of the time. They saw it as a consumable product, so that encouraged many homeowners to loan against the equity in their homes to buy consumable goods. When housing prices declined, they owed more than the house was worth. Many people walked away from their homes while others declared bankruptcy.

    Expected return

    Investors often focus too much on the expected return of their portfolio. While the expected return is important, you must also consider the amount of risk that you need to assume in order to achieve that expected return – the higher the expected return, the more risk you must take on to achieve it. When planning your investment strategy, it is important to be truthful with yourself in evaluating how much risk you can manage, and how long you are able to stay on the course through the ups and downs of the market rhythm. With other words, you should determine how much short-term volatility you are willing to accept.

    A little bit of history.

    An academic named Harry Markowitz introduced the research on what he called modern portfolio theory that people were able to understand diversification in an objective, mathematical sense. This research was so innovative and Markowitz earned a trip to Sweden to pick up a Nobel Prize.

    The bottom line

    In Shakespeare’s play, “The Merchant of Venice,” written more than 400 years ago, the character Antonio demonstrates his understanding of the concept. He says: “I thank my fortune for it – my ventures are not in one bottom trusted, nor to one place, nor is my whole estate upon the fortune of this present year.” That is a diversified investment.

    Risk Disclosure (read carefully!)