Bar Bell? Dumb Bell? It’s All About Risk Management

I got involved in an interesting discussion about Bar Bell investing. The idea comes from splitting risk in bond futures trading or commodities trading. I traded commodities back in the 70’s and in fact saved up enough money I could either go to medical school or buy a seat on the Chicago Jackson street mini-market, so I was more than a little into it. Commodities trading is a zero sum game and a game of leverage. You might but a contract that has a potential for $1 gain but you may pay only 20 cents or 5 cents for the chance. Contracts expire so you can’t just buy and hold, your only choice if you’re in the game is to trade or get the hell out, so you place bets, and you win some and loose some. If you win more than you loose at the end of the year you have a profit, loose more than win a loss. Loose too much you’re busted. So it’s all about wining and its all about controlling your losses such that you have money to play. Commodities trading is not investing. It is trading on a market with the idea of buying low and selling high and the very real possibility of buying high and being forced to sell low. If you loose, what you loose goes to whomever had the other side of the trade your “buy high sell low” pair is his “buy low sell high” pair. If you don’t like that much risk you can do something called spread trades and there are all kinds of spread type trades.

So in a poker game you may have the main game going on and bets on the side. Bets on the side have a different risk of paying off than the main game. By knowledge of the odds of the side bets and the odds of the main game you can improve your risk by making enough on the side to make up to some extent for the risk of the main game. FIRE types do this all the time in fact they plan this into their strategy. They work 10 years with the idea of having that 10 year “investment” generate 60 years worth of income. Sounds psychotic doesn’t it? So they hedge their bets with a side bet called a “side gig”. A little blog or something that generates some income to cover part of the risk of the nutzo 10 years work 60 year play narrative. FIRE types think they are investing but actually they are speculating same as a commodities trader or a poker player. Small businesses fail 20% in the first year 30% in the second year and fully 50% fail in the first 5 years. 30% fail AFTER 10 years. So that little blog is anything but a sure thing. It is the reason startups sell out. Start up, make some money, sell out before you fail. Speculation. So what about Bar Bells?

The Bar Bell portfolio comes from splitting risk in bond trading. You can buy low yeild high quality paper and are pretty much assured of making your coupon. You can buy high yield low quality paper that if it pays off, pays off big but there is a definite risk of default. This is called a spread. You spread your risk between a sure bet which pays you and a speculation which may or may not pay you, and this is why it’s called a Bar Bell. It’s a bi modal risk. Pictorially

Here is a balanced portfolio of known risk and known reward and it sits on the efficient frontier. It has an expected return, the peak at the center, and an expected risk the range of values above +- 3. What if you squish down the center?

You get a bimodal distribution with a risky end (pink) and a safe end (blue). This is a Bar Bell The argument is you split your risk between safe and risky and if risky dumps you still have safe but in reality you have just the same amount of area under the curve in Bell as Bi-Modal it’s just distributed differently. The net portfolio will still work out to some average risk and reward. What if you have a BIG blue and a LITTLE pink but pink has a chance to multiply dramatically or it can go away completely? Lets look at some charts

Here is a portfolio of SPY. You retire in Dec 1999 just before the 2000 .com crash and also experience 2008. You’re a Bogglehead and expect SPY to generate 8.82% return over the long term.

Spy between 2000 and 2018 under performs BY A LOT

You’re expecting 8.82%, your actually getting 4.58% or half of what you expected. SPY experienced 2 recessions in that 18 years and so the volatility ate your lunch and your nearly 2/3 done with retirement! How much “return is it going to take to get you back to your expected 8.82% over the next 12 years? If you started with 1M and compounded at 4.58 x 18 years you would have 2.4M Your expected at 30 years with 8.82% is 12.6M, so at 18 years you are 10.2M under expected and NEED to make 13% / year for the next 12 years to make up the difference. The expected is 8.82% Do you really think it’s going to work out? THIS IS SEQUENCE OF RETURN and this is a real present day example not just some speculation This is exactly what happened to a guy who retired in Dec 1999 with 100% SPY

Let’s Monte Carlo a SPY portfolio for 30 years 4% WR

over 1/10 times you 100% run out of money. You run out of money because of the RISK in SPY

Here is the kicker to 100% SPY

Your portfolio starts dying EARLY. By 15 years it’s already heading down and for some is out of money. Retire at 60 get to 75 Uber Driver here you come!

Lets say you buy only VBMFX which was has been around since 2000. It’s expected return is

almost 5% and in fact it did better than that. Over the past 18 years VBMFX has returned

5.75% since inception in 2000. Bonds have been in a 30 year bull market.

So if you had SPY and took out 4% you could expect 0.6% growth on your money, less than inflation in the past 18 years, where as if you had VBMFX you could expect 1.75% growth about equal to inflation. What happens if you Monte Carlo VBMFX?

You survive 98% of the time but notice purple is headed into the dirt.

What about the kicker, what about the kicker??

The kicker is you don’t start running out of money till after you’re probably dead with this SORR

SPY alone and VBMFX alone are Bi-Modal when you look at them together, and they are almost perfectly uncorrelated as we saw in the example. Stocks under performed Bonds over performed. What happens if you Model a 50/50?

The kicker?

You fail about 2.8% of the time but look at purple, it is barely headed into the dirt and will survive for many years to come. The idea is to then have a “less risky part of the portfolio and a risky part for a Bell so lets add 20% AMZN for a 20/30/50 AMZN/SPY/VBMFX portfolio

Holy Cow! a >99% survival!

The kicker?

All you needed to do was to know to buy AMZN in 2000

Substitute GE of AMZN for a 20/30/50 GE/SPY/VBMFX portfolio Uh oh 89% survival no better than SPY!

It can be even more complicated if you change SORR or Inflation assumptions.

So what does all this mean? By choosing at Bar Bell you are speculating just the same as a poker player with side bets. Some times you win some times you loose, good time Charlie has the blues! How do you apply risk management? 1. You over fund to start. If you start at 20% above your 100% of need it can be a home run or a strikeout. If you’re a 3%/33 type with a million bucks you need 1.2M to start. An extra 200K is roughly an extra 7 years of work. If you strike out, YOU’RE OUT. It means you weren’t cut out to be a speculator. You don’t know what you are doing. Do not put hamburger money in the pot. See #2.

2. NEVER send money from low risk to high risk. You may send money the other way, in fact that’s how you get rich in this kind of scheme, dollar cost average the risk. When things are up stuff some into the mattress When things are down you have your 100% of need so go to the beach. Another way to play this is to completely divorce the portfolios into 2 independent portfolios one for investing and one for speculation. WR is strictly NOT part of speculation. The flow sheet for this kind of risk management is

You are always siphoning profit or principal off into investment never the other way. Here is my story with this technique but not with these numbers. The ratios are correct. In 2005 I bought a penny stock for 10K. It grew to 50K and I pulled out my 10K and put that in BRK.B. This is called a free trade. The remaining 40K was free money. The investment bobbled around till 2015 when I sold that 40K to cash. When I sold it it was worth 50K. I put half in BRK.B and half into BTC. 25K into speculation and 25K into investing. I had made 500% profit, and my principal was tucked in BRK.B plus half my profit. BTC exploded and my 25K went up to 1.5M. On the way up I took out the 25K and put it into BRK.B (free trade) and left the free money alone. BTC crashed OH WOE IS ME? Hell no The money was free money. It could go to zero and I’d be out nothing. As it turns out it’s still up 1300% and I have all that loot in BRK.B to boot. If I went to zero Whoope shit I had a good ride and made some money which I stuffed into BRK.B. But the thing is BTC is not going to zero. BTC is creative destruction and creative destruction multiples. AMZN is creative destruction. Apple smart phone is creative destruction. NFLX is creative destruction. Remember the brick and mortar Block Buster? NOT creative destruction. In the mean time I’m going to the beach quite content to do nothing.

The point is if you had co-mingled the portfolios the risk of one would seep into and erode the value of your hamburger money. In retirement do not let greed eat your hamburger money. Do not be a Dumb Bell because you read a Bogglehead book and think you know something. Reading a Bogglehead book doesn’t mean you know Jack it means you know Taylor Larimore, who’s just an old coot with a system (sorry couldn’t resist). These traders make their living eating your lunch and they are damn good at it. This ain’t bean bag. If you can’t practice risk management, don’t play. If you don’t know what you’re doing, don’t play. Speculation is a zero sum game. Some’s gonna win some’s gonna loose.

4 Replies to “Bar Bell? Dumb Bell? It’s All About Risk Management”

  1. OMG Gasem,

    I seriously do NOT understand most things about investing. I am a perfect example of the “know nothing, do nothing” tribe.

    The main difference between me and most others is that I know that I don’t know. Thus I risk manage around all these things I have no idea about.

    1. You don’t really NEED to know the risk management with a 50/50 Bonds Stocks portfolio. The risk management is built in. All you need to do is work long enough, contribute yearly, and re balance. It is a system that relies on American business and rule of law to bring you along. You merely hitch a ride on the train with some stocks and some bonds adding every year and after a while if the country does well, you do well. America since it’s inception has been wildly productive and so the train riders have gotten rich along with the country. We are the worlds reserve currency so it is cheap and efficient for us to borrow and do commerce. We have rule of law so if there is a dispute a fair and just resolution can be reached. The government is not confiscatory. Things can change this Socialism for example will wreck productivity, open borders destroys the rule of law for citizens who pay for all of this, if we loose reserve currency big hurt time, we have a powerful military so we are not over run and defeated. We have logistics so we can get goods from point A to point B. We have reliable communications so there is no lag in data analysis. Fake news can kill this reliable aspect of knowledge. Tribalism and mercantilism can and will destroy the social compact and adhesion and public trust and world wide trust. If all of that goes down the train will stop dead on it’s tracks and your portfolio won’t be worth Jack.

      The other problem is people tinker with the system. They try and eek more return for free but more return comes with more risk, no free lunch. More risk is called “speculation” Train riders don’t really understand the excess risk of speculation and that adds instability and inefficiency to the system. Also speculators make money by wining zero sum deals which is different than getting rich through by an investment growth and productivity model. If you understand this much, this is about all you need to know. Don’t tinker and speculate if you don’t know how to do that, make sure capitalism and the rule of law and social compact and adhesion is preserved. Get on the train and have a nice ride

  2. To extend your hamburger analogy, you can either burn your buns with gross mismanagement of risk, or tan them at the beach.

    Enjoyed the bimodal risk curve. I think financial samurai recently posted about a similar principle that guides his investments, keep the big kitty safe but place a few thoughtful outside bets with play money where the upside potential is life-changing and see if you get lucky.



    1. I once created a portfolio to analyze using NFLX AMZN BRK.B MSFT GOOG as the stocks and BIL as the cash. The stocks had a 32% expected gain and a 15% volatility when invested in the tangent portfolio ratios of balanced risk vs reward ie best ratios. 3 times the gain of SPY at the same risk. The risk of BIL is zero. In a 50/50 portfolio with BIL you could expect 16% return with 7.5% risk. A SPY/BIL portfolio 63/37 had the same 7.5 risk and 8.9% expected return. Which is the safer portfolio? Answer: the first portfolio. The risk is the same the return twice as much. In one year you will be ahead an extra 8%. Quadruple your money in 10 years instead of double your money. So much for the argument stock picking doesn’t work and you can’t beat the market. Mark Cuban invests like this with the vast amount of his money in BIL. If the market crashes companies of this caliber will be on sale but not out of business by any means. How does the ditty go? low cost index fund… cant beat the market… If you have 4B and risk 0.5B but quadruple to 2 B in 10 years you have 6B. But you need that 3.5 B to be rock solid in order to risk the 0.5B. If your low risk is really moderate risk the thing falls apart. The thing can also fall apart when you start siphoning off money.

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