What is a Dumbbell
Breaking Down Dumbbell
A dumbbell method can be used to take advantage of the best aspects of short-term and long-term bonds. In this strategy only very short-term and extremely long-term bonds are purchased. Longer-dated bonds typically offer higher interest yields, while short-term bonds provide more flexibility. The short-term bonds give an investor the liquidity to adjust investments every few months or years. If interest rates start to rise, the shorter maturities allow an investor to reinvest principal in bonds that will realize higher returns than if that money was tied up in a long-term bond. The long-term bonds give an investor a steady flow of higher-yield income over the term of the bond. Not having all their capital in long-term bonds limits the downside effects if interest rates were to rise in that bond period.
How to Employ a Dumbbell Strategy
The dumbbell method typically outperforms the stock market, so a bond investor has the potential to earn more regular income than in equities. This takes advantage of higher interest rates and minimizes risk without limiting financial flexibility. Because some securities mature every few years, the investor has the liquidity required for large purchases and emergencies. Putting part of a fixed-income portfolio in long-term bonds reduces the risk of increasing interest rates that affect the value of securities with longer maturities.
Once initiated, a dumbbell strategy must be actively monitored to acquire new bonds to replace mature bonds and to continue to provide regular income. An investor may have to wait for other securities to mature before employing a dumbbell approach. Monthly income is not guaranteed to reach an investor’s goals. Purchasing multiple bonds is more expensive than purchasing one, and potential returns may not justify the additional cost. And, risk is not eliminated completely.
In equities, a dumbbell investing approach would be to buy the three top-performing sectors and three bottom-performing sectors from the previous year. Combining a momentum strategy of owning the top three sectors with a value approach of buying the bottom three can yield more favorable returns versus than a buy and hold strategy, depending on the market. In the expanding universe of exchange-traded funds (ETFs), the dumbbell approach can be attractive as well. However, trading costs, taxes and management fees may increase with a dumbbell approach due to more frequent investment turnover resulting in more commissions. It could also lead to more taxes on capital gains unless used in a tax-sheltered account such as a registered retirement savings plan (RRSP) or tax-free savings account (TFSA).