Portfolio insurance isn't a policy, it's an investment strategy. When you use portfolio insurance, you bet on the stock market going up, while hedging against the risk that your investments will tank instead. In theory, by balancing stocks and options on stocks, you can achieve a risk-free portfolio.
An index put option is one way to establish portfolio insurance. Suppose you hold a basket of stocks you believe is going to go up, but market trends have you second-guessing your strategy. To protect yourself, you pay another investor for put options. These give you the right -- but not the obligation -- to sell some of your shares once a particular stock index reaches a given level. The options give you an out that will minimize your losses by selling the stocks at a profit.
Portfolio insurance was born in the mid-1970s. Many investors had dropped out of the market, but Hayne Leland figured they'd return if they could hedge against risk. He began offering a portfolio insurance service. Leland learned that market volatility made protecting portfolios harder: A strategy hedging against a 15 percent market swing didn't help if the swings were steeper. However, Leland's firm eventually developed strategies to cope with highly volatile markets.
Even the best investor can get blindsided by unexpected developments -- wars, shortages, pandemics -- that plunge the market or particular market sectors into free fall. With enough put options at the right price, the profit from selling them can offset most or all of the losses from a bad market swing. If the market continues going strong and the underlying stocks continue gaining in value, you can just let the unneeded put options expire.
Nothing is completely cost-free, including portfolio insurance. It costs money to buy put options, and the more options you buy, the more expensive it is. If you exercise the options the protection pays off, but fees still eat into your profits. If the market stays flat -- if your portfolio doesn't fluctuate much in value during the option period -- then the money you spent on the options won't produce any gains to offset the cost. But you will have bought peace of mind.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.