This post focuses on a technique to attain medium risk in your portfolio with a value investing approach. “Medium risk” seems to be an elusive term, which was well illustrated in the bear market of 2008. In Nassim Taleb book he shares his brilliant “barbell” investing strategy that comes as close to the essence of a medium risk and value investing portfolio as I have come across. He advises that we invest 80-90% of our portfolio’s in Treasury bills, the safest investment class on the planet. The remaining 10-20% should be invested in high risk bets like options.

Taleb’s strategy is unconventional, but lets take a closer look. In the past year we have seen overwhelming proof of investors and economists inability to speculate. Millions of shares of Bear Stearns were bought above $100 before their sale to J.P. Morgan for a couple of dollars and the majority of “sophisticated investors” were only mildly bearish in January 2008. By investing 80-90% of a portfolio in T-bills you create a safe nest-egg. The percent of your portfolio devoted to options gives you a floor on your possible exposure to massive losses in the equity market - you cannot lose more than 10-20% in any given year. At the same time, if your option bets are successful, you have a large upside.

Let us consider the medium risk math - the most recent 10 year treasury notes sold for about 4%  interest rate (which is near the historical low). Lets estimate that all your option investments have a wide range of 50% returns or 50% loses in a year. If 80% of your portfolio returns 4% that effects your portfolio with an overall increase of 3.2% (80 x 4%). The 20% dedicated to options with a +/- 50% return will deliver a 10% increase in your overall portfolio or a loss of 10%, at either end of the spectrum. So overall in a good year of 50% returns on options your overall portfolio will increase 13.2% (3.2% + 10%) and in a terrible year of 50% loss on options your overall portfolio will decrease 6.8% (3.2%-10%). By a show of hands how many people would be happy to have only been down 6.8% this year?

If you are considering treasury bills you can research rates and buy t-bills at the goverment website - http://www.treasurydirect.gov.

Taleb’s proposal is an interesting blend of very low and very high risk that appears to attain true medium risk. I am interested to hear what you think and if you would consider Taleb’s diversification method. The method came from his bestselling book, The Black Swan: The Impact of the Highly Improbable. Taleb is a sucessful hedge fund manager and professor who studies human’s poor ability to make predictions and the effect of “Black Swans” or random, unpredictable events. Taleb’s book is available on Amazon.com:

Happy Holidays!!

2 Intelligent Responses to “How to Create a Medium Risk Portfolio”

  1. Allen Taylor (1 comments.)

    Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

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