What Is Portfolio Insurance?

Portfolio insurance is used to protect stock market investment values.
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If you have an investment portfolio or want to start investing, the idea of portfolio insurance sounds like a good idea. You know there are times when some investments -- such as stocks -- can decline significantly in value and you would like to avoid those losses on your investments. There are ways to "insure" an investment portfolio against declines in the market. The question is whether the benefit is worth the cost.

Volatility of the Stock Market

Portfolio insurance usually applies to a portfolio of stock investments. Over a period of years, stock investing has provided some of the best returns to investors. However, there are periodic declines in the market -- often referred to as bear markets -- which can be painful to a stock portfolio's value. For example, over the course of the 2008 into 2009 bear market, the overall value of the U.S. stock market declined by half. It took several years for the market to climb back up to pre-bear-market values. Upward trends in the market -- bull markets -- can last several years to a decade or longer. Bear markets are quick and deadly -- usually lasting just a few months.

Derivative Securities for Insurance

Portfolio insurance is obtained by buying derivative security types that will go up in value if the stock market declines. The ability to set up portfolio insurance became possible when derivative products based on stock market indexes first became available in the 1980s. With a single derivative security covering an entire stock index, setting up portfolio protection became more cost-effective. Another term describing the strategy of protecting a portfolio is to "hedge."

Alternatives Available

There are several types of derivative securities that can provide portfolio insurance. Index put options are options on a specific stock market index, such as the S&P 500. Puts go up in value if the underlying index declines below a specified level. Futures contracts on stock indexes can be used to profit from a market move in either direction. Selling short index futures provides protection if the stock index declines. Inverse type exchange traded funds are designed to move in the opposite direction of a specified index. There are inverse ETFs available against a diverse range of stock market indexes.

Portfolio Insurance Considerations

There are trade-offs for each type of security used as portfolio insurance. The first decision is how much of a portfolio should be hedged or insured. It is somewhat uncommon to hedge the full value of a portfolio, which would limit or eliminate any gains if the market goes up instead of down. Put options provide low-cost insurance that allow profits to be maintained if the market goes up. The downsides to put options are the cost and limited time frame of the protection. Futures contracts are a low-cost way to provide protection to a larger portfolio. The trade-off is that if the market goes up, the loss on the futures will equal the gains on the amount of portfolio covered. Inverse ETF funds work similar to futures without the amount of leverage provided by futures. To insure with an inverse ETF, a significant portion of the portfolio value must be used to buy the ETF shares.

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