As the growth stocks vs value stocks debate rages on, and value investing undergoes an almost two decade run of underperformance to growth, a new type of stock strategy has gained popularity: the barbell portfolio strategy.
The barbell portfolio strategy is a simple concept; a balanced portfolio containing both growth and value stocks. Like a barbell, the weights of these stocks should counterbalance for adequate exposure to both.
Becoming strategy agnostic when it comes to stock picking can be extremely valuable for several reasons, which we’ll discuss in this post.
But there’s also some downside risk to a barbell portfolio, which we will discuss too.
This post is divided into 6 sections, with each building on the previous:
- Growth vs Value Investing Background
- Pros of the Barbell Strategy
- The Evolution of Growth/Value
- Cons of the Barbell Strategy
- The Most Critical Aspect of Portfolio Strategy
- Common Sense Application of a Barbell Portfolio
Growth vs Value Investing Background
There are many camps of stock pickers, but among the two most popular are “growth investors” and “value investors”.
Typically, each investing style shares common characteristics.
- Growth Investing: Buying stocks in companies with high sales growth, regardless of a stock’s price in relation to those sales (or earnings). Growth stocks typically don’t need to be profitable yet, and can often be younger companies with exciting prospects for big potential growth.
- Value Investing: Buying stocks with proven track records of sales and earnings, and only buying those which are trading at a set relation to those fundamentals. Value investors tend to place more priority on what a company has done rather than what its potential could be.
What makes these portfolio strategies controversial is that many investors, professional and retail, become heavily influenced by these ideas.
It tends to lead to emotional opinions about “the other side”, and also decisions within a portfolio to hold stocks with certain characteristics.
The problem is…
Both sides are right.
It’s well documented and publicized that both growth stocks and value stocks have had long periods of time where one strategy has outperformed the other.
As you’ll often see on Wall Street, once a strategy (or category of stock) becomes popular due to outperformance, the new-found popularity perpetuates into increased outperformance which builds on itself and lasts for a long time.
I won’t go into the specific numbers behind growth investing vs value, but you can read about some of the posts where we dove into that on the blog already:
- Which Investing Strategy is Better – Value vs. Growth Stocks!
- Growth vs Value According to Fidelity’s Peter Lynch: Growth is Better. Mostly…
A possible solution to the growth vs value debate is the barbell portfolio.
A term first used in the context of bond trading and options (and popularized by famed investment author Nassim Taleb, the barbell portfolio strategy is now referred to as a portfolio with a balanced weighting of both growth and value stocks, in concert with a long term investing approach.
Pros of the Barbell Strategy
Rather than make an outright decision on timing a growth stocks or value stocks cycle, a clever investor can simply invest in both types of stocks and profit—regardless of which class of stock does better versus the other.
In a sense you can get the best of both worlds, especially if you implement a “buy low, sell high” approach.
For example, say you have a 50-50 weighting of growth and value stocks, a perfectly balanced barbell portfolio.
Since one part of the portfolio is likely to outperform the other due to the way these strategies have historically behaved, an astute investor can rebalance his or her portfolio along the way. As one allocation becomes heavier than the other due to outperformance, the investor can sell some winners and buy some losers to re-establish the barbell weighting.
In effect, selling winners and buying losers as part of rebalancing is an application of “buy low, sell high”, which should pay off if the market swings the other way AND the investor stays invested long enough to capture that switch.
You might be familiar with this type of a mindset as a common technique in tactical asset allocation, typically between stocks and bonds, where an investor with a shorter time frame rebalances between asset classes to buy more when one class is underperforming and sell the other which is outperforming.
Again, over the long term an approach like the barbell portfolio strategy should work because the market cycles between styles and trends just as it does bull and bear markets.
The Evolution of Growth/Value
A potential pitfall to the barbell approach lies in how the growth and value dichotomy has so far deviated from previous historical trends.
This is only amplified (and perhaps because) of the internet.
Without a doubt, the internet changed the business world forever. Back in the 90s, the stock market over-estimated this change greatly, leading to a “New Economy” mindset which propped up one of the biggest U.S. stock market bubbles and crashes of all time.
But, though the hype about the internet age eventually dried up, the actual expanse of the internet into every aspect of business continued to accelerate.
Is Value Investing Dead? The Internet and Its Impact
No longer do businesses need large capital outlays (and tangible assets) in order to scale up huge levels of growth (in sales, profits, and cash flows).
Companies like Amazon can simply put up a website, and invest in a distribution system that requires much less inventory (tangible assets) than a traditional retailer.
This asset-light model gave Amazon an extreme competitive advantage and allowed it to scale much more quickly than its older peers, because it wasn’t constrained by (tangible) capital outlays and incremental growth.
In the past, a retailer like Walmart had to carry huge inventory in order to stock its massive stores, and was generally constrained in the speed of its growth by how much it could reinvest into new inventory and stores. Growth in that physical world takes time.
But because the internet eliminated both of those constraints for Amazon, the company’s growth was incredibly faster.
In a nutshell, the internet turbo charges the speed of growth.
Not just for Amazon, but for every business model which can create a competitive advantage from the exponentially scalable and intangible nature of the internet.
Cons of the Barbell Strategy: #1
This leads to, actually, one of the pitfalls of the barbell portfolio.
Because of the internet, and the fact that businesses today can rely on intangible assets for growth at a much larger scale than 20 years ago, value investing today is not the same as value investing in the past.
With insane margins possible from asset-light business models (how’s a 90% gross margin sound?!), a company could maintain huge growth in earnings and cash flows with less sales and capex than was ever before possible.
And so, strategies using old value investing metrics like the Price to Book (P/B) and Price to Sales (P/S) have not performed well and are unlikely to perform as well as they did in past outperformance periods for value.
We’ve previously discussed these revolutionary developments in a podcast and the blog:
- IFB171: Why Price to Book Died; VTI 7.0 Update
- Price to Sales is NOT Relevant When Margins Are High – 20Y [S&P 500 Data]
If value investing today isn’t the same as value investing in the past, an investor creating a barbell portfolio has some important decisions to make.
In that—does a good barbell portfolio contain value stocks using traditional metrics, the traditional metrics which are only earnings and cash flow-focused, or none of the above?
There’s risk in that because it’s not an easy answer.
It adds a huge level of uncertainty that’s not easily answered by historical trends.
And of course there’s the possibility that this evolution of business models has been widely over-exaggerated during this latest growth investing boom, and that stocks will revert to a period where value investing is king again—with its traditional metrics and factors reigning supreme once more.
Bottom line: if an investor with a barbell approach doesn’t correctly anticipate this nuanced and difficult value allocation decision, continued long term underperformance is likely.
Cons of the Barbell Strategy: #2
There’s also the possibility of constructing a barbell portfolio and actually attaining the “worst of both worlds”, which can happen through many different ways/reasons:
- Picking the wrong value stocks and wrong growth stocks
- Rebalancing between growth and value at terrible times
- Being too diversified to see an impact, or not diversified enough
- Having doubt in the strategy and not sticking with it long term
Now to be clear, all of those reasons (except the second one) is applicable to all investing strategies when it comes to the stock market, and not just the barbell one.
However, some of these can be amplified due to the inherent nature of how a portfolio with the barbell strategy is supposed to be constructed.
I think this quote sums it up nicely:
“There’s no such thing as a free lunch”–Michael Scott (just kidding)
In all seriousness, there’s no magic pill to finding a stock market strategy that is guaranteed to outperform the market.
It’s actually very easy for the average investor to underperform the market, because there are so many factors and components of long term success… and some luck involved as well.
The stock market, and investing, can give very uncertain outcomes.
The Most Critical Aspect of Portfolio Strategy
Which leads me to a key takeaway for investors, and that is: behavior matters.
The barbell strategy is not easy to implement, just like a good growth strategy or value strategy isn’t easy either. It takes conviction, patience, rationality, and (some) intelligence.
Growth stocks tend to swing much higher on the upside and much lower on the upside, and there tends to be much fewer winners than losers.
Value investing tends to lead investors to select many businesses that are declining or stagnant, at a much higher rate than a typical growth strategy will.
I might sound like a broken record, but there’s really no way to avoid it.
You could use a barbell portfolio to get the best of both worlds, or the worst. Very easily.
I like the way that Jeremy Siegel, Professor of Finance at the Wharton School of the University of Pennsylvania, summarized it in his classic book Stocks for the Long Run.
He essentially said that it’s very easy for investors to get burned by their strategy, and then abandon it for the latest hot strategy, only to continually perpetuate underperformance. It’s just human nature.
Then investors with poor performance can eventually abandon stock picking, concluding that their abilities are not there, but then take those same biases in selecting funds (or ETFs) which underperform for the same reasons.
As Jeremy puts it:
“Those who finally abandon trying to pick the best funds are tempted to pursue an even more difficult course. They attempt to beat the market by timing market cycles. Surprisingly, it is often the best-informed investors that fall into this trap. With the abundance of financial news, information, and commentary at our beck and call, it is extraordinarily difficult to stay aloof from market opinion. As a result one’s impulse is to capitulate to fear when the market is plunging or to greed when stocks are soaring.”
The part about the “best-informed investors” really hit home for me, because I constantly find myself trying to ineffectively prognosticate about the market’s current price and its prospects when it has no benefit to my long term results.
It’s big reason why I’m blessed to be doing what I do, constantly teaching beginners through the blog and podcast, because it forces me to constantly remind myself of the biases that naturally creep in as you manage a portfolio.
Whether you’re building a barbell portfolio, a value, growth, or a special blend of all 3, this critical aspect of investing success can only be achieved through forced discipline and persistence.
Investor Takeaway, and Practical Application
I think building a barbell portfolio can be a great idea for the right type of investor.
You have to be comfortable about it, know why you’re doing it, and follow through. It has to align with your values and what you prioritize, and how you think and where your circles of competence lie.
Here’s a great way to implement the barbell strategy.
Put your growth stocks in a taxable account, and put your value stocks in a tax-deferred retirement account (like an IRA or Roth IRA).
Because you generally want to hold growth stocks over the very long term (for optimal compound interest), and growth stocks don’t tend to pay dividends (which are taxed), you’re probably better off saving the tax benefits for value stocks, since contribution limits to these accounts are limited.
The nature of value stocks reinforces these benefits as well, as a good value strategy tends to require more frequent buying and selling (which is subject to capital gains taxes), and includes more dividends like we touched on.
If all of this is intimidating to you (and even if it isn’t), it’s worth doing your best to not only invest in stocks but also in maximizing your chances for success.
Just as athletes invest in personal trainers and nutrition, it makes all the sense in the world to invest in your mind and psychology when it comes to building up your life savings, since these are among the most important parts of finding investing success.
And so, I’ll let Jeremy take it away with one more great quote from his classic book:
“Proper investment strategy is as much of a psychological as an intellectual challenge. As with other challenges in life, it is often best to seek professional help to structure and maintain a well-diversified portfolio.”
It’s a similar, special kind of professional help that we try to impart through our various services like this blog. While we don’t directly manage money, we provide guidance and mentorship through our newsletters, courses, and tools.
If you’re looking to also invest in yourself, you can do so for free with a subscription to our email list, where we provide guidance and information on all we have to offer, to get you through the toughest parts of investing and building a portfolio.
I highly recommend checking it out, and want to thank you for your attention. I hope to have provided you with valuable insights on the barbell approach to stock picking.
Have a prosperous day.
The information contained in these newsletters and on our website is for general information and educational purposes only. It is not intended as a substitute for legal, commercial and/or financial advice from a licensed professional.