Hello,
yesterday i have read in a book about a guy insuring his portfolio in preparation to a crash. He uses futures. The idea is, that he keeps his current portfolio intact and get paid in a more massive downturn, so he has cash at the bottom to stock up on stocks when they are bloody cheap.
The described downturn is cost of the future, so reducing overall return.
I only have a basic understanding of that strategy, could someone here more literate explain what this is about and if this is a good idea? What would be a back-of-a-napkin calculation say for a 100k portfolio?
Just as with car insurance, portfolio insurance costs money, and you are only insured for a predetermined period of time in both cases. Perpetual portfolio insurance costs additional money for every insured period, just as perpetual car insurance does. You can insure your portfolio using futures or options.
The salient question to answer is, what are your net expected returns? I.e.,
net of insurance costs. If your realized gross returns are 7%, and your insurance costs an average of 8%, you realize a net loss of 1%.
So, it comes down to a question of timing the market. Are you good enough to call tops in the market, and only pay for insurance when you
"know" a hurricane is imminent?
And keep in mind, your cost of insurance floats within its own market. I.e., once everyone else knows (or thinks) a hurricane is imminent, your cost of insurance skyrockets. So you need to forecast the market better than they (the futures or options sellers) do. Furthermore, you also need to forecast when is the cheapest time to buy insurance. Neither are easy to do, and you need to do both better than almost everyone else.
If you're in the market for the long haul, paying for perpetual insurance will be a waste of money most of the time. That's where the insurance metaphor breaks down. A short stretch of market volatility is easily healed without cost, and with enough time; whereas an uninsured car accident can wipe you out.
For portfolio
"insurance" you first have to be crystal clear on 1) what event you are insuring against, and 2) whether you should even care about whether that event happens well before your investment horizon approaches maturity.
Perpetual portfolio insurance will
guarantee that you under-perform the market over long periods of time. It can only out-perform the market if you are either lucky, or if you are very skilled at timing the market, so that you don't pay for insurance when you won't actually need it, and so that you pay the lowest price possible before you will need it.
