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The Best Way To Protect Your Portfolio From Losses

The Best Way To Protect Your Portfolio From Losses

By Expert Panel 20.05.2013


Since the GFC there’s been a lot of talk about ways to protect investment portfolios from the types of falls experienced in late 2008. There are two ways to overcome this risk: portfolio diversification or portfolio insurance (or hedging). We’ve compared the two in this article.

Portfolio diversification involves the practice of combining investments with low correlation to reduce the overall volatility of the portfolio. This invariably means holding some “losers” amongst your “winners”; a practice that often doesn’t sit well with a “winner’s” mindset.

The alternative to diversification is portfolio insurance, or hedging. Hedging seeks to reduce downside risk via the use of derivatives. This approach seeks to neutralise negative market events by taking out a form of insurance with a third party. While it is often sold on the basis that it offers the upside without the downside risks, there is the ongoing insurance cost to consider.

A challenge to implementing the diversification approach is that it generally requires the investor to have a good temperament. Hedging, on the other hand, panders to those who find it difficult to show the patience, discipline and humility that aids successful investing. It offers extra “benefits” that diversification doesn’t – the upside without the downside risk, lots of flexibility to change your mind and a feeling of being a smart investor. But these attributes should come with a clear warning: they don’t necessarily deliver on the promise.

Diversification has been a proven technique for managing portfolios for decades and is considered an efficient (and effective) tool for portfolio risk management. Some may disagree, citing the failure of diversification during the GFC when the movement in growth asset classes was highly correlated. But, in our opinion, diversification (along with an intelligent capital management strategy) offers the better alternative to portfolio insurance for a number of reasons:

        1. It is cheaper than hedging;

        2. It does not involve the use of derivatives that add counterparty and basis risks;

        3. It presumes a more holistic and long term approach that provides significant efficiencies relative to hedging strategies, which generally tend to isolate and segregate risk; and

        4. It’s less expensive to amend or unwind.

When should portfolio insurance be considered for managing risk?

In our view, the decision to insure a risk is a long term consideration. You either choose to insure against a risk or you choose to live with it. Insurance is not something you choose to have one month and not the next. For example, it’s a little absurd to think that you’d consider stopping your insurance against fire and theft this month because you’ve got a feeling there’s a lower likelihood of it occurring. And, then reinstating it next month because you feel the likelihood has increased. We simply don’t “trade” our insurance policies. You choose to either buy insurance or not based on the odds of the risk eventuating (and, of course, its severity).

Unfortunately, when it comes to investment portfolio insurance decisions, many investors seem to want to have insurance one moment and not the next.

To assess the risks involved with investing, we looked at the behaviour of three typical investment portfolios (Balanced [1], Growth [2] and High Growth [3]. We aimed to measure two key risks:

    1. the severity of the risk (i.e. how much capital you could lose), and

    2. the likelihood of not getting your initial investment back.

To assess the severity of the risk, we calculated the worst capital loss for each portfolio over varying time horizons. The results are shown in the chart below:

This historical data indicates the severity of the risk is moderate to minor for the longer investment horizons. For periods of 5 years and shorter, it can be more severe. However, insurance is not necessarily the solution to coping with a concern about short term volatility. Lowering risk exposure is a much more sensible alternative.

With respect to likelihood, we determined the number of periods for each portfolio structure where the end portfolio value was at or above the initial investment amount. We then compared this to the total number of periods to calculate the probability.

The assessment was based on rolling investment periods using historical data since February 1985. The results are shown in the chart below:

It reveals that the likelihood of not getting your initial investment back over longer time horizons (> 5 years) is remote, implying that long term portfolio insurance simply adds cost for little to no benefit.

Over shorter investment time horizons (i.e. <5 years) the likelihood is pretty low and is more easily addressed by reducing your risk exposure (e.g. shifting from a growth to a balanced portfolio).

The historical performances of the investment portfolios indicate to us that portfolio protection insurance is not a cost effective way to manage investment risk. The cost of the protection can amount to around 6% of your capital over 5 years. In the worse case scenarios, that means the best outcome you can expect to get back is 94% of your initial investment.

Be wary of investment options that promise too much

Recently, we’ve noticed an increase in the portfolio protection products available for advisers to use in assisting their clients. Ironically, many of these tools became available in late 2012 (just prior to the recent market uplift). These tools allow you to protect your portfolio exposure over periods from 5 to 10 years. While no guarantee is provided, they offer a minimum outcome equivalent to your initial investment (before protection costs).

Perhaps we’re a little cynical, but we suspect that much of the innovation in funds management is centered around the development of engineered products that pander to immature investor behaviours. Just as the health industry is littered with products that promise you a “Hollywood look” without the need to exercise or change your eating habits, the investment industry also offers apparently painless solutions.

There are much more effective and efficient ways to manage your money. It may require you to overcome some detrimental investment habits, but in our view its far better to learn to deal with your emotions than pander to them by purchasing an engineered investment structure that, at least based on historical evidence, is highly likely to over promise and under deliver.

Click on the links below to read other articles from this week's newsletter

1. 6 Stocks For Yield And Growth (GARP): Why not look for income stocks with good growth...

2. 18 Share Tips - 20 May 2013: 18 Share Tips to BUY, SELL & HOLD from...

3. Many Income Stocks Are Overvalued - So Where To For Yield?: They provide low-cost, index-like returns...

4. The Best Way To Protect Your Portfolio From Losses: Be wary of investment options that promise too...

5. Trade Forex On Herd Instinct: Being a contrarian may enable you to reap...

6. The Frankenstein Economy: From the great recession of 2008 has emerged...

7. Professional Trader: How To Take Trading Losses: I began to manage my trading like I was...

8. Top 10 shorted stocks: Each day we feature the top 10 shorted stocks...

9. Stocks on a roll: ASX rolling 52-week highs for the previous...

10. Stocks on the slide: ASX rolling 52-week lows for the previous...

 

[1] Balanced portfolio comprises a portfolio of 50% exposure to defensive assets and 50% exposure to growth assets.

[2] Growth portfolio comprises a portfolio of 30% exposure to defensive assets and 70% exposure to growth assets.

[3] High Growth portfolio comprises a portfolio of 0% exposure to defensive assets and 100% exposure to growth assets.

 

Wealth Foundations (ABN 95 965 896 114) is a corporate authorised representative of Wealth Leadership Services Pty Ltd (Corporate Authorised Representative No. 319641). Wealth Leadership Services Pty Limited (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369).

The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.



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WHAT’S ON THIS WEEK

week 31 October 2014
    • 27
    • ARG Argo Investments annual general meeting | 4:26 AM
    • BEN Bendigo and Adelaide Bank annual general meeting | 4:27 AM
    • SPO Spotless annual general meeting | 4:28 AM
    • RBA Panel participation by Reserve Bank of Australia (RBA) head of financial stability, Luci Ellis at the Australian Housing and Urban Research Institute panel roundtable | 6:07 AM
    • 28
    • AOFM AOFM to issue $200 million of February 21, 2022 indexed Treasury bonds | 4:05 AM
    • SGP Stockland annual general meeting | 4:26 AM
    • Financial Review's Future Forum Financial Review's Future Forum: The Asian Century, featuring Telstra chief financial officer Andrew Penn, Fortescue Metals chief executive Nev Power and former Australian Ambassador to China Geoff Raby | 4:27 AM
    • WPL WorleyParsons annual general meeting | 4:27 AM
    • WHC Whitehaven Coal annual general meeting | 4:28 AM
    • SGF Challenger annual general meeting | 4:29 AM
    • TAH Tabcorp annual general meeting | 4:29 AM
    • BGA Bega Cheese annual general meeting | 5:13 AM
    • ANZ ANZ-Roy Morgan weekly consumer confidence survey | 5:16 AM
    • DMP Domino's Pizza annual general meeting | 6:08 AM
    • 29
    • MMS McMillan Shakespeare Group annual general meeting | 2:18 AM
    • QRX QRxPharma annual general meeting | 2:18 AM
    • TTS Tatts annual general meeting | 4:06 AM
    • AOFM AOFM to issue $600 million of April 21, 2029 Treasury bonds | 4:59 AM
    • DXS Dexus Property Group annual general meeting | 5:40 AM
    • AGO Atlas Iron annual general meeting | 5:41 AM
    • JBH JB Hi-Fi annual general meeting | 5:42 AM
    • MOC Mortgage Choice annual general meeting | 6:05 AM
    • NIB nib Holdings annual general meeting | 6:08 AM
    • TPI Transpacific Industries annual general meeting | 6:09 AM
    • SUN Suncorp chief executive Patrick Snowball speaking at American Chamber of Commerce in Australia lunch | 6:09 AM
    • GXL Greencross annual general meeting | 6:46 AM
    • 30
    • IAG IAG annual general meeting | 2:19 AM
    • NAB NAB full year results | 4:23 AM
    • AAD Ardent Leisure annual general meeting | 4:24 AM
    • PAS PAS Group annual general meeting | 4:25 AM
    • FDC Federation Centres annual general meeting | 4:25 AM
    • FLT Flight Centre annual general meeting | 4:26 AM
    • PPT Perpetual annual general meeting | 5:13 AM
    • NCK Nick Scali annual general meeting | 5:18 AM
    • HIA HIA New home sales for September | 5:19 AM
    • AOFM AOFM to issue $500 million of Treasury notes, maturing on February 27, 2015 | 5:19 AM
    • FNP Freedom Foods annual general meeting | 5:19 AM
    • TOL Toll Group investor day | 5:35 AM
    • UGL UGL annual general meeting | 5:42 AM
    • ABS Australian Bureau of Statistics (ABS) international trade price indexes for September quarter | 6:05 AM
    • BTT BT Investment Management full year results | 6:06 AM
    • WES Wesfarmers first quarter sales results | 6:10 AM
    • 31
    • ANZ ANZ full year results | 5:20 AM
    • EGP Echo Entertainment annual general meeting | 5:21 AM
    • ABS ABS producer price indexes for September quarter | 5:22 AM
    • RBA RBA to release financial aggregates for September | 5:22 AM
    • NCM Newcrest Mining annual general meeting | 5:22 AM
    • HIL Hills annual general meeting | 5:23 AM
    • AOFM AOFM to issue $600 million of October 21, 2019 Treasury bonds | 5:23 AM
    • MQG Macquarie Group half year results | 6:09 AM
    • ORG Origin Energy quarterly production report | 6:09 AM

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Craig James, of CommSec points out that retail sales grew by 7.4 per cent during the past year, marking the best rolling 12-month period since January 2002

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