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Thread: Understanding the iron strategy

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    Understanding the iron strategy

    Understanding the iron strategy
    For most investment strategists, creating a portfolio begins with determining the degree of risk an investor can take. A young professional may be willing to take a lot of risks. The retiree may depend on a steady income.

    Therefore, the strategist creates a portfolio that divides the funds into three or more groups, each of which represents a class of risk. Speculative stocks such as Initial Public Offerings (IPOs) or small biotech companies are extremely risky. The blue-chips are less risky but still vulnerable to the fluctuations of the economy. Bonds are safer, and bank certificates of deposit (CDs) are the safest ever.
    This young investor might place 40% in speculative stocks, 40% in blue chips, and only 20% in bonds. A retiree may hold 80% in bonds and 20% in blue chips. All of them strive to achieve the best possible return for the appropriate level of risk.

    Iron strategy for equity investors
    Adherents of the Iron strategy might argue that the middle of the risk range should be ignored.
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    Iron strategy calls for the pairing of two completely different types of assets. Only one basket contains very safe investments, while the other keeps only highly leveraged and speculative investments.

    This famous approach allowed Nassim Nicholas Taleb, statistician, writer, and derivatives trader, to thrive during the 2007-2008 economic downturn while many of his Wall Street colleagues faltered.

    Student described the basic principle of the iron strategy this way: "If you know that you are prone to forecast errors, and accept that most risk-taking measures are flawed, your strategy is to be very conservative and extremely aggressive as you can, rather than being mildly aggressive or conservative."

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    The main concerns
    Al Hadids strategy calls for investing in a mix of high risk and no risky assets while ignoring the middle range of moderately risky assets.
    When applied to fixed income investment, the iron strategy recommends pairing short-term bonds with long-term bonds.
    The result gives the investor a cushion of long-term bonds in the event of lower yields, and a chance to perform better if short-term yields rise.
    Parple Strategy for Bond Investors
    In practice, the iron strategy is frequently applied to bond portfolios.

    For investors in high-quality bonds, the biggest risk is losing the chance of getting a better-paying bond. Meaning, if the funds are tied up in a long-term bond, the investor will not be able to place that money in a higher-yielding bond if one of the two becomes available in the meantime.
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    In fixed income investing, there is little incentive to stick to medium bonds.
    Short-term bonds pay less but mature sooner. Longer-term bonds pay more but carry more interest rate risk.

    Thus, in investing in bonds, the opposite extremes are short-term and long-term issues. There isn't a lot of incentive to stick midway.

    Unlike equity investors, where the model advocates investing in stocks with radically opposite risk profiles, the bond investor model proposes mixing bonds with schedules that are too short (less than three years) and too long (10 years or more).

    This gives the investor the opportunity to exploit the higher-paying bonds if and when they are available while still enjoying some of the higher yields of the long-term bonds.

    Not surprisingly, the success of the iron strategy is highly dependent on interest rates. When interest rates rise, short-term bonds are routinely traded for higher interest rates. When interest rates fall, long-term bonds come to the rescue because they keep these interest rates high.
    The ideal time for bond investors to implement an iron strategy is when there are large gaps between short and long-term bond returns.

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    Iron strategy works
    Even for bond investors, the iron approach can be labor intensive and requires frequent attention.

    Some bond investors may prefer the opposite of the iron strategy: the bullet strategy. With this approach, investors commit to a certain date by purchasing bonds that are all due at the same time, for example within seven years. Then they sit idle until the bonds mature.

    Not only does this method immunize investors from interest rate movements, but it allows them to invest passively without the need to constantly reinvest their money.

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