Against the barbell strategy

This is a strange article.

The title and opening paragraph suggest that it is comparing Taleb's "barbell" strategy with other investment strategies -- traditional balanced portfolio, gold in a sock under your bed, highly leveraged penny stocks, etc. -- and finding it wanting.

But none of the actual argumentation that follows really makes any contact with that sort of comparison; rather, it applies uniformly across every asset of the sort Taleb, or your financial advisor, or anyone else interested specifically in your investments, might consider. (With one exception; see below.) And its real point seems to be not to argue for or against any particular investment strategy, but to remind us that there are other things that matter more deeply than the accumulation of wealth. I feel as if I have just read an article entitled "Against the King's Gambit" that's devoted to explaining how playing board games like chess is a waste of time. I wonder whether I am missing the point in some spectacular fashion.

Some specifics:

In a scenario where your country's government collapses disastrously, or where you find yourself on the run from deadly persecution, indeed treasury bonds won't help you much; neither will any other sort of financial asset; how you deal with the possibility of such scenarios is largely orthogonal to how you optimize your investments. Seeking spiritual enlightenment or good advice on what food to eat won't be helped much by treasury bonds; nor will they be helped much by any other sort of financial asset; how you manage those aspects of your life is largely orthogonal to how you optimize your investments.

Children and a spouse and belonging to an intergenerational community are (at least for many people) wonderful things, and perhaps (as this article suggests) they provide many of the benefits that we might (perhaps unwisely) look for from our investments. But having decided whether to marry, how many children (if any) to have, etc., the question remains of what to do with whatever wealth one has after all that, and so far as I can see the choice between "barbell", "conventionally diversified investments", "money in a sock under the bed", etc., isn't affected in any very obvious way by whether one has spouse, children, intergenerational community, etc.

(One thing mentioned in the article that is relevant: "land you are used to occupying and know well". To whatever extent that is an Important Good Thing, it suggests that one substantial asset you should own is a land and somewhere to live built on that land. But I don't think that when Taleb proposes a "barbell" strategy he is intending to tell people whether or not to own a house.)

There are indeed no truly risk-free assets, and any asset you hold may become irrelevant. (Incidentally, this applies to houses and spouses and children and intergenerational communities and religions and so forth too: you may suddenly need to move across the country, you and your spouse may cease to make a good couple, your children may turn against you, your community may disapprove of your lifestyle, you may stop believing in your god(s), etc.) But, once again, this has nothing to do with Taleb's "barbell strategy": the risks that would destroy the value of treasury bonds, and the end of your natural life, will uniformly wipe out any other investments you might have, and the question of what to do with any money you choose to invest is once again largely orthogonal to that.

You completely misunderstood Taleb's point. In fact, you're arguing in favor of it without even noticing, but more on that at the end.

Your basic misunderstanding is that the barbell strategy is not about finding something that's completely safe; it's about dealing with our inability of estimating the real risk behind things that are presented as medium-risk investments.

With low-volatility assets, we need to use plenty of leverage for the portfolio to move at all. However, if we don't know the real volatility (and we never do, contrary to what portfolio-theory people say), it will result in a blowup. LTCM did exactly this: they over-leveraged their investments based on an incorrect model that suggested it was safe to do so and then they blew up when the market moved just a tiny bit more than their model predicted. Medium-risk investments are not always so, but we never know why, and when it turns out they weren't, it's too late and we go bust.

With risky assets, the above problem doesn't exist: we can use small leverages because we know the occasional large moves will take care of moving the portfolio just enough.

Enter the barbell. I'll stick to financial investments here but the same principle applies everywhere. While treasury bonds are clearly not 100% secure, they are as secure as we can have at the moment, so they will be our "safe" 90% of the portfolio and the remaining 10% will go to truly risky investments. Now, let's imagine a 2-fold change in the value of the risky asset; there's an equal probability for the same move up or down. If it moves down, we lose 5% of our value. If it moves up, we gain 10% of our value: this asymmetry is what the barbell is about.

Obviously, not many things double or half in value overnight, and even what does will do it rarely. So, the barbell strategy depends on as many small risky investments as possible, as the frequency of one of them go up enough would increase. (In Taleb's original case, he sold options that he thought were overpriced and, from the profits, bought options that he thought were underpriced. If the market didn't move, he made some money, if the market moved a bit, he lost some money, if the market moved a lot, he made a fortune.)

"Risky investment" doesn't have to mean "dangerous" by the way. Your example of having a bunch of foreign friends is a perfect example for the barbell strategy: you invest a known and limited amount of your "capital" (a few minutes a week of your time) in exchange for a potential, though not guaranteed, upside of unknown magnitude.

If the actual utility you receive as a function of the total "payout" of your "investments" has diminishing marginal returns, then the character of the portfolio to maximize expected utility depends upon the failure correlations between the investment options.

IE, in the case that the utility function is sufficiently convex to payout and the various investments all fail independently of each other, a strategy of investing in only the highest yield and lowest risk choices is not optimal: a small investment in a middling investment decreases the risk of total failure (and corresponding hit to expected utility) enough to be worth the hit to expected payout.

I haven't run the analysis, but my intuition is that advocacy for a barbell strategy limited to just high-risk stocks and T-bills is an empirical claim about the risks along the following lines:

1) The failure of middling risk stock is well correlated with the failure of high risk stock

2) The failure of less-risky investments than T-bills (paper currency, rice & beans under nitrogen, solar panels, etc.) are well-correlated with the failure of T-bills and have lower annual yields.

3) Utility is a moderately convex function of payout. (If it were very convex, you'd want most or all of your funds in T-bills, not just a bit; if it were linear or concave, "risk" isn't a thing and all funds would be in the stocks.)

I'll trust Taleb on #1, and #3 seems reasonable most of the time, but on #2, it would seem to me that while a good portfolio would be based around the high-risk stocks backed up with a small portion of cash-equivalents, the "insurance" against failure of both of those things is cheap enough that it should be included early on.

(As an aside, I'm pretty sure that Taleb suggests "mostly" high-yield/high-risk holdings, with only enough T-bill stuff to keep you off the streets if the stock fails. That's not what I'd pick out as a strategy that is likely to cause bad outcomes because you didn't take enough risk.)

I don't see why the insight fails to apply along a continuum. If you do not have access to Treasury-bond equivalents in the risk you are trying to manage, take whatever the stablest option is for most, and then adjust your exposure-to-large-gains appropriately.

Perhaps this would be something like maintain relationships with your diverse friend group as the safe investment, and then do something for fun once a month where you might make friends with a billionaire as the exposure-to-large-upside investment.