A common theme I currently hear from portfolio managers that publish their opinion via news or posts seems to be centered around the concept of Index volatility and index insurance. More specifically that Index volatility is at a significant low point right now and getting index protection costs very little and that it would be wise for investors to buy portfolio protection. What does this all mean? Let me try to take a quick stab at what it means and share a couple of my thoughts around this topic that I expressed to others in my friend circle.
The Cboe Volatility Index $VIX is a measure of volatility in a broad index like an SP500. At its heart, I understand that to be an expression of how much risk option traders are expecting in the next 30 days. And currently, the $VIX has been trading in a low range for a while. That also means the cost to purchase portfolio protection is significantly low. One can for example protect their portfolio through purchase of Options contracts to hedge downside risk. Right now, option prices are significantly low given all other things going on.
Portfolio managers that express their view points in news media keep pointing out that protection is cheap right now and so investors should consider buying insurance. While I dont disagree with the sentiments of these managers nor the statements around purchasing protection, I don’t believe all investors should follow this advice blindly. Let me explain.
At its heart, portfolio protection is achieved through purchase of Options contracts (like Call options on the $VIX or Put options on the broad index) and sizing these to match ones portfolio. In essence, you pay a premium for certain level of portfolio size and are guaranteed against downside loss risk beyond a certain level.
But there is a key aspect with these instruments that makes them risky and that is timing. Specifically, option contracts have a time range for validity which means you are essentially trying to time the market with respect to protection. And you followed any reasonable investment advice, you are bound to have heard the saying “It’s hard to time the market”
Portfolio protection makes sense for portfolio managers as their performance is measured at strict intervals. May be its 3 months or 6 months or 12 months and certainly against some benchmark index that are being evaluated against. In such cases, portfolio protection helps them contain losses and deliver on portfolio performance at those strict measurement intervals. In short, they have a time range that they are managing the portfolio against. But as, individual investors you do not have those constraints. This is by far the biggest advantage individual investors have on their side.
So if individual investors have infinite duration, another way to look at it is to say there is no set date for performance assessment. And if thats the case, is portfolio protection useful for individual investors? May be. Or may be not. It’s not a cut and dry answer but it’s not always an Yes. Blindly following the advice to buy protection when its cheap will eat away at your portfolio performance in form of premium paid on these options contracts.
You can buy options contract and size it to your portfolio and thereby achieve downside protection for your portfolio, but that requires you to constantly keep placing these options in play and thereby pay premium. Also you risk playing the timing game where you have to get the timing right with market downturn happening while your contracts are still valid. Again, this might be right for some investors. But there is another option that that perhaps more appropriate for individual investors. Its called Risk Management through Position Sizing
If you are thinking of portfolio protection, what you are essentially thinking of is “How much downside risk am I comfortable taking?”. You resolve this through portfolio position sizing. What I mean is to size your positions such that you know and are comfortable with loss sizes for your largest positions. If you have significantly large position in certain stock or sector, a company or sector downturn can lead to losses larger than what you may be comfortable with. If so, you manage that risk through right sizing the position which can be done by rebalancing your portfolio to reduce the risk.
When I say “losses you are comfortable with”, this is two dimensional and very specific to you the investor. The first dimension is the size of the loss and the second is the duration of the loss.
The loss size is the absolute value of the loss, say 20% or 30% loss of value in your portfolio. That could be huge for some. Heck, that huge for me! But what’s more important is the second dimension, duration of loss. A 20% loss over a week or a month is significantly less painful than 20% loss over a 1-year duration. If you need to pull money out of your portfolio at anytime during that downturn duration, you are then effectively locking in those losses and your portfolio won’t have the room nor the time to recover the loss.
Risk management through Position Sizing lets you understand your tolerance for the risk and also helps to size your portfolio such that you are able to hopefully let the portfolio remain intact through the loss period and come out the other side when the market recovers.
So the next time you hear that protection is cheap and investors should buy it, take a moment to ask yourself: Do I have a fixed performance window I’m managing against? If the answer is no, consider whether right-sizing your positions might be a simpler and more cost-effective way to manage your downside risk. Not every piece of institutional advice translates well to individual investors — and that’s okay!