Last Updated: June 22, 2009
When it comes to financial planning, it's not uncommon to think about insurance and investments as two separate things. You use insurance to manage risks — the risk of getting into a car accident, or getting sick, or becoming disabled. You use investments to build your wealth.
But now, in the wake of last year's stock market collapse, financial planners are exploring ways to insure your investment portfolio, and especially your retirement portfolio, against the risk of bear markets.
"We insure our houses, cars, jewelry, art, our professional integrity, etc., as they have significant value," according to FPA member, Dr. Somnath Basu, professor of finance at California Lutheran University and the Director of its California Institute of Finance. "Then why would we not insure our investment portfolio, which if anything is typically equal or greater value than many of our financial, intangible and real assets."
In the purest sense of the term, Basu said portfolio insurance simply means the transfer of pure portfolio risk of loss in exchange of a premium, much like any other insurance product. Since the crash of 1987, the meaning of the term has been distorted as it became associated with program trading, which was more a technique for portfolio rebalancing using computerized trading rules.
But now, in the wake of the crash of 2008, he says there's a proper role for insuring an investment portfolio against loss from changes in market or other conditions. Now, the products available for such loss mitigation, range from the simple technique of diversification to more complex techniques of income smoothing and derivative-based techniques such as collars and spreads.
If you interested in insuring your portfolio, Basu recommends that you work with a competent financial planner who has experience with such techniques. Find a financial planner.
Options were created in the 1970s mainly to manage risks. While they are very powerful risk management tools when used properly, they are also very easy to abuse for very speculative and even gambling purposes. Unfortunately, the sensational cases of abuse have garnered much media attention to the extent that most people have become extremely wary of these instruments; even the mention of the "option" word can send many otherwise seasoned investors to run scared. However, there is a simpler way to understand these instruments. A few examples follow. At a minimum, Basu suggests that you take the time to learn, if nothing else, the simplest form of insuring your portfolio and the purchase of put options.
According to Investopedia, "A put option is an option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. This is the opposite of a call option, which gives the holder the right to buy."
Here's how it may work, according to Basu. "A put option becomes more valuable as the price of the underlying stock depreciates relative to the strike price. For example, if you have one September 2009 XYZ Company $10 put option, you have the right to sell 100 shares of XYZ Company at $10 until September 2009 (usually the third Friday of the month). If shares of XYZ Company fall to $5, you can purchase 100 shares of XYZ Company at the open market rate of $5 per share and then exercise your put option. This put option exercise allows you to sell your 100 shares at $10 per share to the person who sold you the option. It is your (legal) right to be able to sell for $10 and the put option seller is obligated to buy from you at the specified ($10) price. Doing so, your gross profit is an amount of $500 (buy 100 shares at $500 and sell them at $1,000). Your net profit would exclude the amount you paid for the put option contract (the option premium). If the price of XYZ Company does not go down, all you lose is the premium. You can also decide on how much premium you want to pay.
"The proper way to consider a put option is to compare the put to insuring your car or house. For example, if you end up in an accident or your house burns down, the insurance company will compensate you for the amount of the loss. You have transferred the risk of loss to the insurance company and you pay a premium for the policy to the insurance company. If the premium is too high, you can use a higher deductible on your car or underinsure the value of your house. Of course, if you
do not have any accidents or nothing happens to the house, you do not "exercise" your policy and lose the premium only. If the house price goes up, you enjoy the benefit. If you had owned XYZ Company stock in the previous example to begin with, you would have a very similar experience. Further, if your XYZ Company stock gave you a right to sell at $8 (instead of $10 or underinsured) you would have paid a smaller premium. Unlike an insurance policy, this method of risk transfer using derivatives rests in the field of investments and are very handy tools (in the very right hands) to protect your investment portfolio. Advanced strategies (using call options and combinations of various options) exist to craft finer insurance and risk transfer strategies."
Insuring your investments with puts and other instruments can be complicated. "However, just because it may be complicated, doesn't mean that you should not do it," Basu said. "In the midst of the current financial crisis, it is obvious to most planners that client portfolios should have some protection against downside non-diversifiable risk," according to Basu, who recently taught a course on the subject to members of the Financial Planning Association. "It's important that financial planners have an understanding of the products, their associated costs and the conditions that signal when such insurance should be purchased."