This week, I had the opportunity to enjoy a quite spirited discussion in my investing group.
The original question was this:
“Hey team, I’ve got some fresh $$ to deploy. Looking to generate income to live off of. If you come across any interesting opportunities, looking for 10-20% return on cash.”
This question comes up quite often with the founders I speak to. There are a multitude of opportunities that generate these types of returns, from private credit funds to multi-family syndications. These types of investments are very popular, and I know many people who have poured a lot of capital into them.
But I don’t. Not anymore.
One of my favorite feelings in the world is having my mind changed. A few years ago, I would have been at the front of the line looking for sexy alternative funds that yield 14%.
After studying and learning from some of the best family offices and wealthiest individuals in the nation, I have evolved my thinking regarding alternatives in this “mid-yield” range.
First, let’s seek to understand why these types of investments are so popular.
I believe that the rise in popularity of alternatives is due to unprecedented access to information about how ultra-high-net-worth (UHNW) families allocate their investments. Reports like this one from Tiger 21 show that UHNWs are invested up to 29% in private equity and other alternatives, their largest percentage allocation. Fixed income and cash only make up 11% and 8%, respectively.
It would make sense to think that we would want to emulate the wealthiest portfolios. Success leaves clues, after all. If this is how the UHNWs are doing things, shouldn’t we take a page from their playbook?
The problem is that UHNWs (investable assets of $30MM+) are solving for a different outcome than high-net-worth individuals ($1M+) who are seeking to become UHNWs.
Early in my career, I believed that my job was to maximize every dollar and every opportunity. Why would I invest in something that only yields 8% when I can get 16% with this private investment? I thought the only reason people invested in regular things like municipal bonds was because they didn’t have access to the good stuff.
I couldn’t have been more wrong.
Here’s what I learned: the path to ultra-high net worth isn’t about swinging for the fences. It’s about minimizing mistakes.
Enter the Barbell Strategy.
When I first learned about this concept, it kind of blew my mind.
The barbell strategy, popularized by Nassim Nicholas Taleb in his book Anti-Fragile, is an investment approach that emphasizes balancing risk with safety by combining two distinct types of assets. Imagine holding a barbell in your hands, with heavy weights on both ends but nothing in the middle. This metaphor represents the two extremes of the barbell strategy: on one end, you have very safe, low-risk investments (the “safety” bucket), and on the other end, you have high-risk, high-reward investments (the “swing for the fences” bucket). The middle, typically filled with moderate-risk investments, is intentionally left empty.
Here’s how it works:
Safety Bucket: This part of the portfolio is filled with assets that are extremely safe and liquid, such as government bonds, cash, or other low-risk, low-return investments. The primary goal of this bucket is capital preservation. It’s the financial safety net that ensures your wealth is protected regardless of market conditions.
High-Risk Bucket: On the other end, this bucket contains high-risk, high-reward investments. These could be speculative stocks, venture capital, cryptocurrencies, or other alternative investments. The idea here is to allocate a small portion of your portfolio to assets that have the potential to generate outsized returns. Most of your wealth is protected in the safety bucket, so you can afford to take these risks.
For founders who have not sold their primary business, the majority of their net worth is tied up in an illiquid, potentially risky asset.
Once we exit, covering spending safely becomes even more important.
Because of that, our job with our investments should not be to grow as quickly as possible by maximizing returns but to create as much safety as possible by engineering out risk.
Essentially, most of our high-risk buckets are overflowing. We need to fill the safety bucket as quickly as we can.
The safety bucket is full when we have built a low-risk, cash-flowing portfolio that covers spending for the rest of our lives. I call this reaching “Escape Velocity.”
So why do UHNW only invest 8% of their portfolio into fixed income?
This is where it’s helpful to think in terms of actual size rather than relative allocations. They have filled up their safety bucket to cover their spending so that no matter what happens in the market, their lifestyle will never take a hit. They are beyond escape velocity.
Once the safety bucket is full, with the very next dollar, they can swing for the fences in alternatives.
I used to swing for the fences with alternatives because I thought that’s what rich people did.
But I was only partially right. The hidden part of the picture is that the UHNW portfolios I was trying to emulate had already filled their safety bucket, whereas I had failed to do so.
I assumed that because they allocated a smaller relative size to safety, it wasn’t important.
But I learned that rather than an afterthought, the safety bucket is the cornerstone of the portfolio.
For individuals with a net worth between $1 million and $20 million, the barbell strategy offers a more practical approach to achieving financial freedom while managing risk.
First, the safety bucket ensures that your core wealth is protected, which is crucial if you’re still working towards financial independence. With this security in place, any gains from the high-risk bucket become a bonus rather than a necessity.
For those still on the journey to financial freedom, a significant setback can be catastrophic. The barbell strategy’s focus on safety first reduces the likelihood of such losses, allowing you to reach your goals faster.
With your core wealth secured, you can afford to take more aggressive bets in the high-risk bucket. If these investments fail, your overall financial health remains intact. If they succeed, they can significantly accelerate your wealth growth.
Through this lens, we can now answer the original question: What about those private credit funds that yield 14%?
The problem is that these assets have poor risk-adjusted returns. Consider a municipal bond portfolio that could yield 7%. The private fund offers double the return!
But consider this: the private credit fund has more than twice the risk of a municipal bond. There is a non-zero chance that the entire capital invested could be totally lost.
When we invest using a barbell approach, our primary goal is to reach escape velocity as quickly as possible, and any setback resulting from a capital loss will keep us from our goal.
This is the playbook I wish I had at the beginning of my career. Had I followed this strategy, I would have reached escape velocity at 36 years old. Instead, I’m slowly rebalancing as all of my illiquid investments pay out, one by one.
In the end, it was a much more circuitous path to get here. I’m fortunate that it all worked out. I took a lot of risks that I shouldn’t have, and I’m lucky that the few paid for the many.
To filling our safety bucket first,
Mb
