Before purchasing portfolio insurance, the investor should consider the cost of coverage—in particular, the cost the marketplace extracts for bearing portfolio insurance risk. One way to gauge this cost is to compare the results from portfolio insurance with those from a reasonable alternative portfolio management strategy.
Portfolio insurance suffers in comparison with an “optimal” portfolio designed to maximize the rate of growth of portfolio value over time. Over a variety of assumptions for market volatility, interest rate, time horizon and insured floor, the insured portfolio can expect a lower continuously compounded rate of growth than a comparable optimal portfolio. The insured portfolio is also more likely than the optimal portfolio to achieve only the guaranteed minimum return.
The economic cost of portfolio insurance can be substantially reduced by lowering the minimum return requirement and by lengthening the horizon over which the insurance program is implemented. Furthermore, portfolio insurance (at least as conventionally implemented) comes closest to offering optimal results when investors are highly risk averse.
