Portfolio Insurance–Is it just for wimps?

Several months ago a friend of mine asked me to take a look at his portfolio. The effects of the credit crunch were just beginning to be felt and he was concerned. His stocks were beginning to decline along with the market and he wasn’t sure what to do. He wanted my opinion.

His portfolio consisted of seven high-cap stocks that had experienced terrific growth over the past year. Five were in the basic materials sector (all mining stocks), two were energy companies, and one was a tech (Apple). Besides the fact that his portfolio was highly undiversived, I told him that the major market indices were breaking major support levels and he should consider lightening up as well as rebalancing his positions. He wouldn’t hear of it. He did his due diligence and felt that all of his selections were great companies with solid management teams and tremendous growth potentials, and that he was in them for the long haul. Fine. I said that if that’s the case, he should at least take out some portfolio insurance. He snarled back saying that insurance is for wimps and besides, it cuts into one’s profits. I pushed his portfolio back to him, smiled sweetly, and said that I couldn’t help him since he obviously knows what he’s doing and doesn’t need my advice. (Actually, I think he only wanted to show me his portfolio just so I’d be impressed with his profits. He might just as well have pulled out a big wad of money. Ugh. Like that ever works.) I haven’t heard from him since which is fine and dandy by me.

Glancing at his stocks today, the total value of his portfolio is down 25% from the October highs when I spoke with him. (I’m assuming that his portfolio is equally weighted, but I don’t know that for a fact.) Not that I care anymore, but how could he have cut his losses without sacrificing his positions?

The answer is he should have purchased some insurance when he had the chance.

There’s an entire field of investment theory devoted to the concept of portfolio insurance. Many a career has been built on it and a lot of it involves complex mathematical equations. But for the average investor who wants to minimize risk, a certain of amount of insurance makes sense and it’s not that tough to comprehend nor to execute. The three most popular strategies for the individual investor are index puts, married puts, and collars. (Note: Fund managers also use index futures to hedge their positions but I feel that this is outside the scope of most non-institutional investors.) Each strategy deserves a discussion on its own, and I’ll be addressing each one in upcoming blogs. Stay tuned!

(I can hear you groaning right now, but I feel it’s my fiduciary responsibility to at least introduce you to these concepts. Insurance is never a sexy subject. Just be glad I’m not talking about taxes!)

Notes on Today’s Market Action: Well, my friend might be feeling a little better today since the energy and basic materials sectors are up so far. The chart of the XLB, the materials Spider (an ETF), has been in a classic down trend since November making lower highs and lower lows. It may have put in a bottom on Jan. 22, but I don’t think an upward trend can be confirmed until it surpasses its $42 resistance level. The energy sector Spider (XLE) has fared better in recent months, probably due to the high price of oil. Lately the price hasn’t been able to break 71 1/2 (why is this trading in fractions???), and needs to break 74 1/4 before I’d pay attention to it.

Tech is the big winner today. The semis (SMH) and the internet architecture (IAH) ETFs look like they might be putting in a double bottom. Only time, as they say, will tell. Actually, none of the sector ETFs that I track are looking very attractive. Even the emerging market funds that were galloping upwards at break-neck speeds earlier in the year are looking wan. I still maintain that until the US economy shows signs of firming up, the safest place to be is in cash.

Posted by Dr. Kris at 12:25pm PST

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