A Barbell strategy consists of making sure that 90% of your capital is safe, and using the remaining 10%, or on risky investments. Applied to business strategy, this means having a binary approach. On the one hand, extremely conservative. On the other, extremely aggressive, thus creating a potent mix.
Barbell strategy in a nutshell
A Barbell strategy, a la Taleb consists of making sure that 90% of your capital is safe, by investing it in Risk-Free assets, which cover from inflation. On the other hand use 10%, or the remaining capital for very risky investments.
Few people can coin a new word, and one of those is the options trader, writer, and philosopher Nicholas Nassim Taleb. He introduces the concept of Black Swans and how to deal with that in his three books series called “Incerto.”
Before men discovered the existence of Black Swans in Australia, empirical evidence showed that they did not exist.
The problem with empirical evidence is that it can only be falsified rather than prove to be right or wrong ultimately. In other words, there will be not a final theory in science, or in socio-economical life, that will be right forever.
Instead, a method that works better compared to the previous ones. Until a new, evolved theory, therefore falsify a previous one. It does not mean that the former assumption was wrong, but rather not as complete as the new theory.
What does this introduction have to do with investing? The investing world is plenty of gurus, which affirm to be able to read the markets.
The problem is that this is not possible, not because they are not knowledgeable enough but somewhat because they are too indoctrinated with their theories and, therefore, they fall into the narrative fallacy.
The narrative fallacy is a bias that we all carry, but that the so-called “experts” seem to carry the most.
In other words, we tend to give an explanation and create cause-effect relationships between events, which are not related at all. In short, with words we can create stories, those stories fit a narrative, which is deviant from reality.
Also, while experts in the domain of physical things, maybe really able to have a better understanding of that domain, this is not the case for social areas.
As Taleb puts it,
“if you put 1000 people in line and you take the person who weighs the most in the world, that person will represent thirty basis points of the total (0.30% of the total);”
instead, if you take 1000 people and you want to measure how the wealthiest person in the world will affect the total, you will be astonished to see that person representing 99.9% of the total.
Mediocristan vs. Extremistan
In other words, Taleb classifies our world in two domains, a first domain, called Mediocristan, like the weight example. And a second domain, called Extremistan, like the wealth example.
In the weight example (mediocristan), one single rare event minimally impacts the total. In the wealth example (extremistan), instead, one single rare event will make the total. From here, we go back to our idea of black swans.
Socio-economics is classifiable as an extremistan domain, where one rare event can make the total. Therefore, the problem here is to understand the difference between rare events, or “Black Swans” which can be classified in “Positive Black Swans” and “Negative Black Swans.”
In other words, we want to avoid negative black swans, while we want to completely expose ourselves to positive black swans. But how does this concept apply to finance and investments?
To take advantage of positive swans while avoiding negative ones, you have to take an opposite approach in the same domain. In short, you want to cover yourself from blowups while also making yourself exposed to unlimited upsides.
The barbell strategy
This strategy translates into the Barbell strategy, elaborated by Taleb. This strategy mainly consists of making sure that 90% of your capital is safe, by investing it in Risk-Free assets, which cover from inflation. On the other hand use 10% of the remaining capital for very risky investments.
Risky investments such as options, or rights but not obligations to either buy or sell a stock in the future. The cool thing about options is the fact that you know the downside beforehand (the cost of the option), although, you don’t know the upside (as Taleb puts it “The sky is the limit”).
While this strategy can be used in investing, it can also be used in other domains of life. The interesting theory coming from Taleb’s book is intriguing since it can be expanded to the point of making yourself “antifragile” to life.
This new word coined by Taleb differs from robustness. Indeed, while robust things are resistant, “antifragile” things, gain from disorder. In an uncertain, extremistan world, becoming antifragile can be the answer and solution to life’s meanest problems.
The Four-Week MBA is an online community. The article above is not meant as investment advice, but rather as an educational article. For investment advice consult an investment professional.
The barbell strategy in business to manage innovation bets
Continuous improvement of the core business model
Also, seemingly asset-light companies, like Google, who are software-first, need to spend billions per year to keep improving their core products at scale.
This is one side of the barbell, the conservative one.
Take the case of how Apple, over the years, has swallowed its most successful products, from the iPod to the iPad, to create an industry based on the iPhone.
Thus, placing these speculative bets is critical to potentially creating larger and larger market opportunities; while they have the potential of cannibalizing their business model, they can evolve into something new, larger, and more in line with the future business context.
The drawbacks of standardized metrics
Taleb explains why standardized statistical metrics, used by some, are worthless.
The most common mistake is seen in equity portfolios.
Some investors opt to, on the one side, stack with aggressive high beta equities, while the other could be populated with defensive low beta equities.
Believing that they are conveyed according to a barbell strategy.
Note that the term “beta” measures how much equity moves relative to its index.
For American investors, this tends to be either the S&P 500, Dow Jones, or NASDAQ.
If the NASDAQ increased by 3% and the stock increased by 12%, it has a relatively high beta value of 4.
In other words, it moves four times as much relative to its index.
A more defensive stock may have a beta value of 0.4, which means it may only move 40% as much as the underlying index in either direction.
Some stocks also possess negative betas. This means they go down when the index is up and vice versa.
None of these measures conveys any real value.
In fact, Beta is not only a flawed financial metric, but it’s also a misleading one.
Key Highlights of the Barbell Strategy:
- Origin and Concept: The Barbell Strategy, introduced by Nicholas Nassim Taleb, involves allocating 90% of capital to safe, low-risk assets and 10% to high-risk investments. This binary approach aims to balance extreme conservatism with aggressive risk-taking.
- Black Swans and Empirical Evidence: Taleb’s concept of Black Swans refers to rare, unexpected events that have a profound impact on systems. The strategy is based on acknowledging the limitations of empirical evidence and the difficulty of predicting such events.
- Mediocristan vs. Extremistan: Taleb categorizes the world into Mediocristan, where rare events have minimal impact, and Extremistan, where rare events significantly influence outcomes. Socio-economics falls into Extremistan, which necessitates managing exposure to both positive and negative Black Swans.
- Positive and Negative Black Swans: The strategy aims to avoid negative Black Swans while exposing oneself to positive ones. This involves being protected against catastrophic events while benefiting from significant upside potential.
- Barbell Strategy in Finance: In finance, the Barbell Strategy suggests allocating 90% of capital to risk-free assets that cover inflation and using the remaining 10% for highly risky investments, such as options. The strategy offers a limited downside and potentially unlimited upside.
- Antifragility: Taleb’s concept of “antifragility” goes beyond robustness by suggesting that systems can benefit from disorder. The Barbell Strategy, in an uncertain world, helps individuals and systems become antifragile and thrive in the face of challenges.
- Business Application: The Barbell Strategy can be applied to business innovation. It involves maintaining continuous improvement in the core business model while also making unrelated bets on breakthrough innovations. This approach balances stability with the potential for significant leaps forward.
- Continuous Improvement and Unrelated Bets: The conservative side of the business Barbell Strategy focuses on continuous improvement of the core business model. The aggressive side involves placing speculative bets on potentially disruptive innovations that can reshape the industry.
- Drawbacks of Standardized Metrics: Taleb criticizes the use of standardized metrics like Beta, CAPM (Capital Asset Pricing Model), and WACC (Weighted Average Cost of Capital) in financial strategies. These metrics are considered flawed and misleading when applying the Barbell Strategy.
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