Finance

Barbell Strategy

Barbell Strategy

Options are a conditional derivative instrument that allows the buyer of the contract to buy or sell a security at a chosen price. Option buyers are charged an amount called a “premium” by the sellers. Options are divided into “call” and “put” options. In a “Call” option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price called the exercise price or strike price. In a “Put” option, the buyer acquires the right to sell the underlying asset in the future at a predetermined price.

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What is Barbell Strategy?

Barbell strategy is an investment concept that suggests that the best way to strike a balance between reward and risk is to invest in the two extremes of high risk on one end and no risk assets on another end while avoiding middle-of-the-road choices. If the degree of risk is tolerable by the investors then only it is possible to seek the best return on investment. Investors who follow the barbell strategy suggest that the only way to achieve that is to reach the extremes. Barbell’s strategy is basically pairing two different types of assets, where on one side there are extremely safe investments, while on the other there are only highly leveraged and speculative investments.

How barbell strategy is composed?

Investing with a barbell strategy offers you a way to gain exposure to a particular bond maturity length without having to invest your entire portfolio in the same segment of the market. If an investor wants exposure to ten-year maturity he could invest all of his cash in ten-year bonds.

A bond barbell does not necessarily need to have equal weight on both sides. It can be heavier on one end and light on the other.

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Example:

Suppose you have 80% of your net worth in cash and you store it in a high-interest savings account, protected from inflation. Then you invest the other 20% in highly-speculative currency (Bitcoin). Bitcoin is the riskiest asset you could buy. It’s highly volatile and could easily go to zero. This 80/20 split is the Barbell Strategy where one end of your barbell is at extreme risk, while the other end is in extreme speculation (Bitcoin).

Pros and Cons:

Pros:

  • Reduces interest rate risk since short-term bonds can be reinvested in a rising-rate environment.
  • Includes long-term bonds, which usually deliver higher yields than shorter-term bonds.
  • Offers diversification between short-term and long-term maturities.
  • Can be customized to hold a mix of equities and bonds.

Cons:

  • Interest rate risk can occur if the long-term bonds pay lower yields than the market.
  • Long-term bonds held to maturity tie up funds and limit cash flow.
  • Inflation risk exists if prices are rising at a faster pace than the portfolio’s yield.
  • A mixture of equities and bonds can increase market risk and volatility.

Bottom Line:

The barbell strategy may not be a conventional strategy. Investor’s expectations have been seesawing between falling into a depression and V-shape economic recovery, creating ripples that affect all asset classes in all the markets. Investors are encouraged to modify the traditional version of the barbell and make it suitable for their applications.

AuthorSaachi Lodha

About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.

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