The way you have been told to structure your portfolio and manage your risk is wrong.  You were told to think of your portfolio as a pyramid.  At the base are low-risk, low-return assets like bonds, preferably governments.  Then a smaller layer of blue chip, dividend paying stocks, or an index fund or global equities fund in the middle.

Almost at the top of the pyramid are small-cap stocks, development-stage biotech, junior gold miners and the like.  At the very top, the tiniest point, are options.  Many financial advisers will tell you to ignore both of these two top layers.

But there are two big problems with their advice.  The first is that it’s very hard to control your absolute risk this way.  Sure, you can control your relative risk by shifting some money at the margin back and forth, such as from bonds to stocks.  But then along comes a black swan event like 2008 and your retirement portfolio gets killed anyway.  The second problem is that the pyramid isn’t likely to generate enough returns to make up for those losses and give you a comfortable retirement.

To put it another way, an investor goes from $500,000 in their retirement plans in 2007 down to $150,000 at the present time. Compounded at 5% a year (a typical “pyramid” return rate), it will take 26 years to get back up to $500,000.  That’s a long time to wait just to be made whole. Worse still is that the remaining $150,000 could as easily turn into $50,000 over the next 26 years if the market has another black swan fit.

So if using pyramid advice to manage your portfolio going forward can’t get you to where you want to be, why do it?

Be a Barbell Investor, Not A Dumbbell Investor

Your only defense is to view your portfolio as a barbell.  On one end should be extremely safe investments that will give you a fighting chance against inflation, deflation or whatever comes — with very little risk of blowing up.  That might be 80% to 95% of your whole portfolio, depending on where you are in your investment life cycle.  So one end of your portfolio has very low or no risk, with high yields.

At the other end should be high-risk investments that will pay off huge if they work out.  Not too many of them, with not much money invested in each one.  And nothing in the middle. That’s right, no index funds, no blue-chip mutual funds, no junk bond funds, no diversified funds…nothing.  You’ll know the risk in the safe end of your portfolio is very, very low.  You’ll know the risk in the other end of your portfolio is very, very high.  You’ll control your overall risk by moving a little money from one end of the barbell to the other, because when you don’t own anything in the middle, it only takes a small shift between the two ends of the barbell to make a big difference in your overall risk.

On balance, most investors will wind up with a medium-risk portfolio.  But unlike the other guy’s collection of mutual funds, blue-chip stocks and ETFs, you will actually know how much risk you are taking, and where.  That is about 90% of the battle for investment survival.

What Goes In The Safe Investments?

Cash in the form of U.S. dollars in Citigroup (NYSE: C) is not a safe investment.  U.S. 30-year bonds are not a safe investment.  They would both be hurt badly by high inflation.  You have to “stress test” your portfolio under a wide variety of possible scenarios, including the extreme possibilities of hyperinflation or Great Depression deflation.  The world’s current economic systems are still fragile, if not unstable, and probably will be for the next few years.  So the likelihood of another black swan event is higher than usual.

What’s safe in this environment is a small number of deep-value and/or high-yield securities of global multinationals, a few trust and royalty companies that pay out 90% of their income, and a small number of mispriced corporate bonds.  In the mortgage REIT sector I like Annaly Capital Management (NYSE: NLY) with a15.4% yield and Walter Investment Management (AMEX: WAC) paying 11.7%.  In energy, take a look at Teekay Tankers (NYSE: TNK), the shipping company paying 11.6%.  There are several business development companies to choose from, including BlackRock Kelso Capital (NASDAQ: BKCC) paying 12.4%.

What Goes In The “Pay Off Huge” Investments?

The idea here is to take a lot of risk with a small amount of money on an improbable event that, if it does occur, will make you a large amount of money.  For example, you could buy far out of the money two-year puts on the euro, betting that the euro zone will break up over the next two years as Spain, Italy, Belgium and Ireland follow Greece down the tubes.  Or you could buy far out of the money calls on hyperinflation by using silver or gold.

Using options, you could short the S&P 500 and go long gold, or short the 30-year U.S. Treasury bond, and stay short as long as Larry Summers and Ben Bernanke have a government job.

My favorite places for the “pay off huge” portion of a portfolio are development-stage biotech and medtech companies, underfollowed (often completely unfollowed) technology stocks, and junior gold miners.  The stocks I recommend usually are so depressed, sometimes by naked short-selling, that I’m not likely to lose any money.  My risk is more that nothing happens for a long time.

Right now, I recommend investors get heavily into Antares Pharma (AMEX: AIS) for a new product roll-out by partner Teva Pharmaceuticals (NASDAQ: TEVA), Arena Pharmaceuticals (NASDAQ: ARNA) for an FDA Advisory Panel recommendation for approval of their weight loss drug on Sept. 16, BioCryst Pharmaceuticals (NASDAQ: BCRX) for a Japanese stockpile order for their seasonal flu antiviral, and CombinatoRx (NASDAQ: CRXX) for a successful roll-out of Exalgo, their controlled-release analgesic marketed by Covidien (NYSE: COV).

Investors damaged by the various bear markets over the last decade need to get to very safe ground with most of their assets.  Nobody knows what’s coming next.  But those same investors need to deploy a small amount of money into a few potentially very high return situations if they are to have any hope of recovering their losses and moving on to acquire enough assets to hit their targeted needs.  That’s the barbell strategy, and it is the best way I see to control your risk while getting to your objective.

As of this writing, Michael Murphy was recommending Antares, Arena and BioCryst to subscribers of his New World Investor newsletter.

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