This is a hypothetical take, and an eye-opener perhaps; a starter to begin to ruminate on: the price of risk.
Before venturing into the idea of a stock market barbell, we should say that this is an idea we have not chosen for ourselves. But we all love to get a good price, right? So it's still interesting to consider how one can think around getting a good price for risk.
A high price of risk
One aspect with any portfolio is to look at the price of the risk in the portfolio. Is the price we pay for the risk, well, ... fair? And what could one even mean with that?
As we all know, stock market downturns can be long, and severe, and as usual worse than all we've seen so far, and certainly deeper than data from the last 50 years shows. We think they can be more nerve-wrecking than more hardcore investors might give the appearance of.
And what do we get for that stock-market-risk? Well, the average return for the total stock market was 8.3% (excluding inflation) for the last 50 years in the US.
Even more interesting to consider is perhaps the safe withdrawal rate. For many of us, that's the penultimate goal we are after. The safe withdrawal rate for the US stock market, dividends and all, was 4.3% for the same last 50 years, which is the foundation for the famous 4%-rule.
What do we need to pay to get that return and withdrawal rate?
Part of what needs to be paid for the average stock market return certainly relates to 10-11 year periods of nail-biting until the numbers get back into black.
For some, the story ends there. But perhaps, as often when haggling about a good price, that shouldn't be the end of the story.
Creating a barbell
How can one get a better price for risk, without going into obscure financial wizardry?
One thing to do is to construct some kind of barbell.
What is a financial barbell? It's about instead of going for the average, somehow balance extremes instead.
And example: one part of a portfolio can be something quite vanilla like a total stock market fund. Then we add something that is also quite risky, something perhaps as explosive as stocks, or even more explosive, but for radically different reasons - so to speak on the other side of the bar.
This is not quite the same as regular 'diversification', but something more fundamental, another beast all together out on the other side of the barbell.
One actually wants the barbell to be a dangerous thing, that is very sure to swing heavily in another direction as the market moves.
So it's not per se about reducing risk, but spreading it out to the opposite extremes, using it to one's advantage, and make sure it behaves differently from one's other assets.
There are very elegant ways of constructing a barbell, but let's be frank, they are not quite accessible to us more average investors.
But just because some of the more elegant ways are only available to advanced investors, or the very wealthy, that doesn't mean that there is absolutely no way to get a better price for risk for the rest of us.
So let's construct our barbell.
We use the US stock market for illustration, but the same is true in most parts of the developed world.
First, we need a barbell that is heavy enough and volatile enough to actually matter at the other side of the stock market. Of course both size and volatility matters. In this example, we are satisfied with a 20% size of our portfolio for the other end of the barbell.
But as said in the beginning, this is hypothetical. If you check the links below, you can see that what we actually did ourselves was not to have an asymmetrical barbell, but a very symmetrical approach, and we went for four different weights - two barbells - instead of two weights - one barbell, as the example here.
Going less than 20% of the portfolio value in the barbell-asset? Then one must beware, so one is not falling for the siren's call of average return and upside potential, and the protection becomes so small that it's just illusionary.
By mixing in 20% of another asset class that is (also) volatile but under other risk conditions than the stock market, one reduces the volatility of the all stock market portfolio so much that, well, these strategies become quite powerful.
We suggest considering gold as barbell. It's conservative, has been around in finance for a few thousand years, and is easily accessible in physically-backed ETF:s. Something else might work, as long as it's volatile enough, moves fundamentally differently from stocks, and can be supposed to still be accessible when the knifes are falling.
The barbell strategy of course also assumes that we keep that 80% 20% ratio over time, for instance with yearly re-balancing.
What happens then?
The 80/20 portfolio, surprisingly, just gives a tiny drop in the average return compared to the stock market index. It's as small as 0.4% difference for the US example, almost just a day of trading.
But, and here comes the much better price on risk, there's quite some things that we gain for those tiny 0.4% we pay with.
Suddenly, the safe withdrawal rate over the last 50 years increases to 5% (a very tangible increase, 7 k€ more to spend from a 1000 k€ portfolio, each and every year, adjusted for inflation, until death does us apart).
Large volatility is dangerous for the safe withdrawal rate. Hence one gets a much better rate if one manages to keep the volatility lower, and especially mitigate the extremes.
The time to recover from a downturn also shrinks much, and becomes a much more liveable five-six years, and the deepest loss is around 30% instead of a nerve-wracking 50%.
Let's say that years to recover is what we "feel" that we pay for average return, and let's put the results in a table:
So what we want is the return, and what do we pay? A reasonable way to think about what we pay for the return, is the number of years until our portfolio is back on track.
The usual definition of price is what we pay divided with what we get.
So, looking at the table, the price for the risk seems to be 50% better with our barbell.
This is an illustration of what one can feel in one's gut. There's something strange, perhaps even unfair, with the price one pays for the risk in the total stock market.
There's a better price to pay, with higher safety.
One might even dare to say that only a fool would go for a sub-optimal price on risk.
A court fool. But even the Romans had buffoons to entertain their dinners.
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