In a recent column in The Globe and Mail, Rob Carrick wrote about a financial adviser who says he is investing based on a new fangled strategy called “the risk barbell”. A barbell is an asset allocation strategy that provides exposure to asset classes at the two extreme ends of the risk spectrum. The adviser says he puts three quarters of his portfolio in low risk assets such as Government bonds and the rest in high-risk penny mining stocks. It is very hard to evaluate a strategy such as this without knowing more about the risk-return characteristics of penny mining stocks.

It is true that an investor can obtain spectacular returns by picking the right penny stock. If you had picked up Aber or Aurelian Resources back when they were penny stocks, your investment would have become a ten bagger many times over. But that’s a bit like saying if you pick the right combination in the LottoMax draw, you can turn a $5 “investment” into $50 million. The key question is how likely is it that an investor will pick a winner out of the thousands of penny mining stocks that trade on the Venture exchange?

Research into penny mining stocks is hard to come by but I did find one study that looked at returns on stocks trading in the over-the-counter (OTC) markets in the US. The study covered a 9-year period and examined the returns from more than 7,000 stocks that traded in the OTC. The findings in the paper, titled Do investors overpay for stocks with lottery-like payoffs? An examination of the returns on OTC stocks, will be sobering for investors interested in penny stocks. It found that more than half the stocks in the sample lose more than 95% of their value (and in the interest of fairness, it must be mentioned that slightly less than 1 percent of the stocks in the sample returned 1,000 percent or more) and average annual returns were -30 (minus thirty) percent. A $1,000 investment in OTC stocks would, on average, turn into $30 over a 10 year period.

If penny mining stocks were to have similar return characteristics as US OTC stocks, an investor can, on average, expect a total loss of the capital allocated to the risk portion over time. One would hope that this particular risk barbell strategy does not require an investor to regularly rebalance her portfolio!

This article has 20 comments

  1. Maybe when the barbell lands on your foot you smarten up and choose a better investing strategy.

  2. Ok, how does all this square with the efficient markets hypothesis whereby markets price securities correctly on average?

  3. I can only see it working for individuals who are in the mining sector at the managerial level.

    • @Canadian Investor: I don’t buy into EMH myself. For me the arithmetic that all investors cannot be above average alone is enough to justify indexing.

      In this case, it appears that “investors” are buying into the lottery effort. i.e. they are willing to overpay for the tickets for the opportunity to make out-sized gains, even if the probability of those gains are very small.

      @Cal: I agree. Some insiders may be able to make successful bets on mining stocks.

  4. @CanadianInvestor: Good question. Is the -30% retrun an arithmetic average or a compound average? If it’s compound, then this makes sense. Scratching for other reasons, is there anything that makes it difficult to short these stocks?

  5. Mr. Carrick meant to call it a “dumb-bell” strategy not a “barbell” strategy.

    Insiders make a lot of money in these thinly traded stocks. As they say, a fool and his money…

  6. @Perry: LOL — now my nearby coworkers are certain that I’m crazy sitting here laughing to myself.

  7. It’s not impossible to make money in small cap mining and oil and gas stocks. I used to know a couple guys in the oil and gas industry who knew how to follow mineral rights applications and a variety of other publicly available sources of information. When these investments go well, they go very well. Most are scams though. There is no regulation FD in Canada, so it’s possible that this VP at TD does have the ear of some of these companies in a manner that’s not quite insider trading. Nassim Taleb used to follow a similar barbell strategy, but with options.

    I had to laugh at the example in another article in the Globe and Mail today, where this guy intended to buy shares of IAU on the NYSE but ended up buying IAU on the TSX by accident (a small cap oil and gas company) and walked away with a 500% return.

  8. @Michael James: The paper mentions that though shorting would theoretically be very profitable, they offer many reasons why it may not be possible in practice (one reason is many OTC stocks are not available for shorting). The authors also point out that actual experience of long investors is likely even worse because of the wide bid-ask spreads on these illiquid stocks.

    @Perry: That’s a very good one. Thanks for the chuckle!

    @Viscount: It’s happened to me a couple of times with VTI. I forget to set the market to US and TDW pulls up a quote for Valdor Technology International Inc. Fortunately, I notice that it is trading in pennies, not $60 or so, and I notice it in time to catch the error.

  9. For some people a barbell strategy may work- emphasis on the “some” but penny stocks are not a stock for the average investor. Almost sounds like they ran out of story ideas and tried to legitimatize a fringe topic.

  10. I’m not sure I would call this a barbell strategy. Typically, a barbell strategy tries to maintain the same portfolio risk but do it with very low risk assets offsetting high risk assets with a positive expected return by high variance of returns. I don’t think as a sector you can say small cap mining stocks have a positive expected return, as you demonstrate.

  11. Nice one Perry!

    I’ve heard of this strategy before, but I think it was something like use 90% safe fixed income and then the other 10% used things like options which obviously are fairly risky, but at least the underlying securities are regular stocks (unlike junior miners).

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  14. That’s incredible; a negative 30% per year. This makes penny stocks equivalent to “investing” in the lottery! Great post.

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  16. @CanadianInvestor: I do happen to “buy into” the EMH (or a variation thereof) and I think there are a couple of possible answers to your question.

    First, tax incentives like Flow-Through Shares could actually be making it profitable to invest in these things even if they lose money. I know very little about FTS so I may be talking nonsense here.

    Second, the EMH doesn’t apply if you’re talking about an investment whose benefits are not financial. For instance, I fully expect my box of Cheerios to depreciate to nothing over the course of a few weeks, but that doesn’t prompt me to ask why the EMH fails to value them at $0. If the buyers of penny stocks get something other than money out of owning them (like, I dunno, the thrill of the chase or something) then that would increase their fair price.

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