Would You Like Insurance? A Look at the Cost of Hedging

Have you ever played blackjack when the dealer flips over an Ace and asks, “Would you like insurance?” It seems like a reasonable wager. The dealer, with an Ace showing, only needs a 10 or a face card to complete an unbeatable hand. By wagering half of the amount of the bet you already have placed, you are assured that if the house hits blackjack, you will at least break even.

But the odds against the dealer hitting blackjack are 9:4. In other words, for each 4 dollars you wager, you should win 9 dollars if the house’s next card is a 10, Jack, Queen, or King. Put another way, the dealer has a 69.23% chance of NOT hitting blackjack and collecting your insurance premium. But remember, the payout is just 2:1. Paying out 2:1 when the odds are 9:4 are a great business model for a casino, but not so much for a bettor, or an investor.

Clients frequently ask about insurance. Life, disability, and long-term care are probably the most common topics of conversation. But when the market is roaring, such as been the case since the end of the Great Recession, an increasingly popular question has centered on methods of insuring, or hedging, against portfolio declines.

There are a couple of ways to approach this topic. One is to look at statistical models to try and understand what the odds of a particular market outcome may be.  I discussed models in last week's Accountable Update. I also found a couple of 2016 articles, one in Forbes magazine and another on the blog Six Figure Investing, that discuss specific statistical models for calculating probabilities of different market outcomes.

For those that find the finer points of statistics more helpful for curing insomnia than finding your next investment, perhaps some real life examples of the cost of insurance will be helpful. We already looked at the raw deal a blackjack player receives at a casino, but another concept that just about anyone with a car probably understands, auto insurance, may provide a better comparison.

I shopped around on the internet and determined that insuring a $30,000 car with a good driving record in Texas will run about $1500 a year with a $500 deductible. While this was by no means a comprehensive study on those rates, it can provide us a guideline for how much insurance costs. In this case, it’s about 5% of the value of the vehicle to cover damages that exceed $500.

One of the most common ways of “insuring” an investment portfolio is to buy a put option. A put option, in simplest terms, is a contract that allows you to buy the right to sell a stock or index at a predetermined (strike) price at some point in the future. In other words, you can “put” it to the person who sold it to you, sort of like you put the body shop bill to the insurance company after a fender bender.

Say you have a $1,000,000 stock portfolio invested in a S&P 500® index fund that you wanted to hedge. The index closed yesterday at 2307.87. Let’s say you are concerned about a greater than 10% drop in market value over the next month or so.  A 10% drop would result in the index dropping to around 2078. Think of the 10% as your deductible, it is the losses in excess of 10% that we are concerned with protecting against. For the purposes of this example, I selected a put option at the 2080 level that expires on March 10.

To hedge a $1,000,000 position, you would first need to determine the number of contracts necessary to insure potential losses. The formula is to take your market value of your portfolio divided by the notional value of the index contract (Strike price x 100). An S&P 500® put option at 2080 x 100 = $208,000. $1,000,000/$208,000 = 4.8, which we’ll round up to 5 contracts.

5 contracts of the SPX 2080 Mar 10 Put would have cost about $1250 each, or $6,250 for the next 28 days of protection. If you repeated that each month over the next year, you would spend approximately $75,000 to insure your portfolio for a drop of more than 10%. In this example, the current cost of insuring your portfolio against greater than a 10% drop is about 7.5% on an annualized basis.

The difference between insuring your car versus your portfolio is that you can’t get around if your car isn’t working. If you aren't planning on touching your portfolio for a while, then you generally can withstand some volatility in exchange for higher expected returns.

On the other hand, if you will need to use your money in the near term, it likely is much less expensive to keep those funds in cash or bonds that are much less volatile. The tradeoff is that they earn less, but the net result is likely to be less expensive than buying protection on a stock portfolio.

This is why we advocate allocating enough of your portfolio to those less volatile assets to allow you to weather the occasional inevitable volatility. A 2.5% return may sound unappealing, until you compare it to the cost of portfolio insurance. Then, it doesn’t sound so bad.

Insurance is a necessary and useful tool to help manage risks in the right circumstances, but casinos and investors typically don't get rich by paying out more than they earn. Keep that in mind the next time you are pondering a hedge to your bets. Even better, get in touch to discuss your situation.