If you find someone who thinks it is smart to go without insurance for their house, you might think they are insane. After all, our home is a large asset, protects our family’s safety, and provides the comfort of a roof over our heads. Our vehicles are worth even less and get the same treatment. Ask many investors what protection they have for their portfolios, which are often worth more than their home, let alone their car, and you will typically get a blank stare.
According to the Insurance Information Institute, 95% of all homeowners carry insurance, and of those, approximately 6% file a claim in a given year. 97.7% of those claims result from property damage or theft. Property damage from wind and hail, water damage, and fire make up the bulk of these losses. While fire results in the largest claims, wind and hail damage are reported at 10x the rate of fire. Using simple math, we can determine that any one person would file a claim on average once every 16 years.
If we look at the investment market, from 2000, the S&P dropped more than 10% five times and more than 20% another five times (using only month-end numbers). Unlike damage to a structure, the market can “fix itself” by recovering losses. Large drops in the index can take years to recover; however, as we have covered in previous articles, including “A Better SPY?” that addressed the potential for better approaches to the market.
So how would one “buy” insurance for their portfolio? After all, insurance companies would probably not want the exposure of providing it. This occurs for a few reasons, namely that losses would impact their customers at the same time, their investments also would be impacted, and the risk is unpredictable, so underwriting would be difficult or impossible to calculate. Investors, therefore, have a few choices:
- Hedging with puts
- Timing (sitting on cash)
With 15 years in the futures industry, I will continue to loudly proclaim that diversification is the wisest and simplest thing every investor can do for their portfolio. Using non-correlated assets that make money alongside traditional asset classes over long periods can offer a “free lunch” of better risk-adjusted returns with lower volatility. I would also argue that futures trading, with its non-directional nature and ability to profit from all sectors on the long and the short side, offers perhaps the most attractive non-correlation of any asset class.
People often think about trend following when they hear about the futures market. Much like the recessions of the early 2000s, 2008, and 2020 the IASG Trend Following Index is once again positive YTD by over 9% during a declining market https://www.iasg.com/en/indexes/trend-following-index. Manager A, which is Adalpha Asset Management’s Short Term Program referenced in this article written in 2020, discusses the benefit of this strategy alongside the S&P, which is also up 9% YTD. Like previous periods, a declining market showed more predictability and larger moves that were easier for CTAs to trade. The key is to use bonds, real estate, commodity exposure, or any other asset classes that can profit when your portfolio is struggling.
Options can be used strategically to hedge risk as well. The benefit of these is that they can offset your risk perfectly. The downside is that unless they pay off, they result in a total loss of investment. We covered many of these drawbacks in our article, “Why Traditional Hedges Fail.” These include the fact that the amount you spend on the hedge accumulates over time and often matches the loss had you just skipped it entirely. Timing is another idea, but decades of research show that not only are retail investors poor timers, but professional investors are as well. Keeping some cash on the sidelines can be a viable strategy, but the dangers shown with the current inflation rate and a 0% return on this money guarantees a loss.
So why doesn’t everyone utilize insurance for their portfolio? The simple reason is that insurance is often painful to buy. It hedges a future unknown potential risk but costs money now. Like insurance, some alternative investments underperform in normal market conditions. This should be expected. The key is to re-balance portfolios annually or after large shocks and remind yourself of the purpose of each component of your investment strategy. After all, we do not buy insurance on our house because we enjoy it. We do so in case it catches fire. This year the market has been burning. Don’t get caught without protection.
Please call or email me if you feel that you need a better risk management plan for your portfolio.