Life is filled with uncertainty and we can’t always predict what will happen next. But if something negative does occur we want the damage to be as minimal as possible, a sentiment that applies to investors’ portfolios as well. Mitigating the damage caused by unforeseen events is the guiding rationale behind the insurance industry. Life insurance, health insurance, homeowner or renter’s insurance and automobile insurance are all designed to help insulate us from the “slings and arrows of outrageous fortune.” But what about insurance protecting against loss in an investment portfolio, does it exist?
Unfortunately there is no formal insurance policy an investor can buy that will make his or her losses whole should the markets plummet, but that doesn’t mean you can’t take steps to protect against a downturn. It’s a lesson too many investors have learned the hard way, which makes protecting yourself paramount.
Let’s take a look at what “portfolio insurance” could look like.
One classical form of downside market protection is to put a portion of investments into more conservative asset classes, such as bonds. That approach can certainly help limit losses, but it does so by keeping a substantial portion of assets on the sidelines, which can limit the potential for portfolio growth, especially in a low interest rate environment.
To counter this, after the market upheaval of 2007-2008 quite a few equity investment products were launched that claim the ability to grow assets while still controlling for downside exposure. Most of those products look to mitigate risk through either market timing, which means predicting the right moment to move money out of equities and into other assets such as bonds or cash or by investing in equities that exhibit lower volatility and/or lower beta (e.g., smart beta).
However, neither of these products can provide a defined outcome similar to insurance. To illustrate this, let’s use a boat as a proxy for one’s nest egg and a hurricane in place of a market crash. Market timers would assume they could get the boat out of the water in time and to a safe place before damage was done, and therefore have no need of insurance. That strategy requires as much luck as skill and may at times cause the market timers to exit when they don’t need to or potentially stay in when they should have left. Alternatively, lower beta seekers would buy a bulky, sturdy boat – the extra strength offers some protection, but not actual immunity, from a storm. Another drawback is the fact that the boat drives more slowly.
As stated earlier, there is no way to buy insurance on your portfolio, but there is a stock market analogy to the insurance, which is using option strategies, which we believe is the most elegant solution.
Buying a downside put on the market can effectively protect portfolio assets from downward spikes. Granted that expense can seem wasted if the market doesn’t spike down, but taking that attitude would be like resenting all the money wasted on medical insurance because you didn’t get sick this year.
Let’s look at an example. Assume the S&P 500 is trading at 2000. If an investor owns the S&P and wants to protect from losses of more than 10% over the next 12 months, the investor can simply purchase a 12 month 1800 strike put (the cost for this purchase is effectively the “insurance premium”). If the S&P finishes below 2000 but above 1800 (i.e., less than a 10% drop) in 12 months, the put expires and the investor is out the loss in the S&P (think of losses above the 1800 mark as the insurance deductible). If the S&P finishes below 1800, than the put has value at maturity equal to the market drop below 1800 (the gains in the put are the equivalent of an insurance payout). In this scenario, the investor cannot lose more than 10% as any further losses in stock value will be equally offset by gains in the purchased put. Voila! You have your insurance!
A word of caution, however: To the novice, obtaining this sort of option driven protection can be challenging and difficult to understand. Options are complex, expensive, and very powerful. Deciding which options to purchase, at what price, and on which underlying securities takes a serious understanding of markets and a significant amount of time, which is why outsourced options solutions chosen with the help of a trusted professional advisor make the most sense for many investors.