Methods of Portfolio Insurance

Methods of Portfolio Insurance



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Portfolio Insurance is a method of protecting the principal of a portfolio in volatile markets. As the name of the concept would imply, there is a cost associate with protecting against significant downside variance. In much the same way one would view homeowner’s or auto insurance policies, the cost of portfolio insurance becomes an unnecessary expense in rising market environments and a drag on total return. The “value” of portfolio insurance, extending the analogy, becomes apparent only during periods of market duress. Ultimately, the value of various portfolio insurance strategies is determined by volatility. There should be consideration for the use of portfolio insurance purely on a tactical, as opposed to strategic, basis. That would mitigate the costs associated with hedging. The flaw with that approach, however, is that volatility is a coincident indicator. Thus, when most needed, the hedges might not be in place, and upon a sharp decline in the market, the associated spike in volatility would render the resulting hedge cost prohibitive. Therefore, portfolio insurance strategies should be utilized during times of low volatility and when fundamental and/or technical indicators suggest such protection is most needed. Since most stock market corrections have durations of 2 – 3 quarters, the tactical component of the strategy is relevant with respect to when the hedge is lifted.

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