Drawdowns Done Two Ways
Est. Reading Time: 10-12 Minutes
“They shouldn't even call it insurance. They just should call it ''in case sh*t.''
l give a company some money in case sh*t happens. Now, if sh*t don't happen, shouldn't l get my money back?”
- Chris Rock, 99’
Our typical opinion of insurance is influenced primarily by those forms being required of us by law such as driving a car OR when our downside loss is so great its utility is not questioned such as life insurance.
Although somewhat skewed by the requirement by law or your lender, the approximate percentage of Americans with various forms of insurance are as follows:
Health – 91.4% Life – 54.0% Home – 85.0% Car – 87.0%
If we held the costs of these coverages static but removed the legal requirement to carry it the percent of participation probably wouldn’t drop too much in aggregate. There would be some reduction, but the bulk would likely come from the uninsured drivers category.
The point is this, when it comes to risks affecting life, limb and our general comfort we seem to inherently understand the value of insurance. We may not like it, but we realize that the loss associated with a potential health, house or vehicle mishap can easily be greater than our earning potential to dig our way out of it.
However, things seem to get reversed when we make investment decisions.
While there are many sentiment indicators and surveys on what participants in the market are thinking, perhaps the quickest way to gauge the opinion of the need for investment insurance is in the amount of margin debt investors are willing to take on.
Margin can be thought of as the anti-insurance. Rather than minimize our loses it exacerbates it. It should follow that the more margin debt you are willing to shoulder the less afraid of drawdowns you must be.
Looking at the red columns in the chart, which turn negative the more margin debt investors hold, it would seem that investors have not felt the need for too much insurance for some time now….Stocks only go up after all.
I can’t argue with the sentiment. Of the various forms of non-specialized insurance, they are all expensive.
Let’s take a look at buying puts (the right to sell a share back at a predetermined price regardless of how low it goes) and shorting credit risk (benefiting if fixed income goes bearish). Both of these are somewhat simple and binary forms of pure downside protection in the public markets.
For those who love white papers, The Best of Strategies for the Worst of Times: Can Portfolios be Crisis Proofed? is a great examination of a few popular methods of hedging downside risk (i.e. investing insurance).
For those who don’t need a sleeping aid, the highlights as it pertains to Put Contracts and Shorting Credit Risk are as follows:
Puts are 100% effective in protecting against downside risk during drawdowns
Average annualized returns were a disappointing (7.4%) despite an average gain of 42.4% during drawdown periods
Shorting Credit Risk is also 100% effective during drawdowns
While better than buying puts, shorting credit risk still returned a lackluster annualized return of (3.6%) across all time frames