How Small Caps Can Make Your Portfolio "Barbell" Strong

In the midst of all the financial noise -- bank bailouts, frozen credit markets and plummeting stocks -- a new idea in portfolio theory is quietly emerging.  It’s called the "Barbell Strategy."

The strategy calls for an investment on both ends of the risk spectrum, with nothing in between.

That means investing in zero-risk investments, like government debt, money market instruments and CDs.  And then investing an equal amount in high-risk, speculative investments, like small-cap stocks.

The portfolio entirely omits the medium-risk/medium-reward investments, like blue chip stocks, that typically dominate most portfolios.  Thus, when the portfolio is plotted along the risk spectrum it looks like a barbell.

Nicholas Nassim Taleb, bestselling author of "Fooled By Randomness" and "The Black Swan," first made noise on Wall Street for his brilliant execution of the Barbell Strategy.

He won’t say exactly how well he did, but estimates have him booking anywhere from $20 million to $45 million in profits in a single day.  Taleb is obviously an incredibly gifted investor, but the strategy has merit regardless of one's investing IQ.

That said, I'm not advocating a complete barbell strategy for your portfolio.  I'm just pointing out that small-cap investing, when implemented properly, will have a huge effect on your portfolio.

Now, because of the speculative nature of these stocks, I recommend that no more than 20% of your portfolio be allocated to such companies.  But the impact of that 20% may surprise you.  To illustrate...

Take a hypothetical portfolio of $100,000 and allocate 80% of it among stocks, bonds and the traditional range of investments.  Put the remaining 20% in more aggressive small-cap stocks (split evenly among 10 companies).  Now let's assume that the 80% portion of the portfolio returns 8% a year.  And the 10 small-cap companies perform as follows:

We get stopped-out of three companies (losing 50%), two companies trade completely flat (no gain or loss), two companies net 40% gains, one company gains 80%, one company gains 160% and one company nets us a home run gain of 320%.

The table below shows the difference a portfolio that includes a 20% exposure to small-caps can have over time.  It's shocking.


We think these assumptions are fair.  They’re largely based on the investing exploits of the late Sir John Templeton, who in 1939 bought 100 stocks in the throes of the Great Depression.  Back then, any investment in stocks was considered a high-risk endeavor.

But Templeton was betting that the upside potential of the winners would more than offset him for the losses he incurred on the losers.  He was right.  Between 1939 and 1943, Templeton's investment grew from $10,000 to $40,000, despite several companies going belly up and losing everything.

The important thing to remember is that risk is not to be feared so long as it's managed properly within your portfolio.  If you hunt for big gains intelligently and carefully, you’ll quickly find the extra return you've been looking for.

Louis Basenese
Contributing Editor
The Tycoon Report