Putting up with some insurance

Insurance is the biggest pain in the neck you can’t do without. I’ve lost count of the hours I’ve whiled away chatting to insurers’ call centres. Although, to be fair, most of that time was probably spent on hold.

Still, it’s a commanding argument for the importance of insurance as a concept that, despite all that pain, those premiums and wasted youth, I continue to deal with insurers. And I’ll wager you all do as well. Insurance is just too important – it’s that backstop that prevents disaster becoming destitution. I think the same way about insurance in our multi-asset funds. Thankfully, portfolio insurance tends to entail fewer exasperated phone calls. Of course, there’s no Portfolio Insurance® product that you can call up and buy. Your insurance comes from creating a well-diversified portfolio, and, in our case, this has included some more intricate trades of late.

When constructing a portfolio, the correlations between assets are crucial. If all the eggs in your basket are connected by string, you can bet they are all heading for the floor if one of them is. You shouldn’t be upset if some parts of your assets are falling when the others are rising – that means you’re diversified! If everything is going up together, you shouldn’t be celebrating. Instead, you should take it as a warning and investigate why. It’s probably a strong signal that you’re in for an ugly patch in the future.

Some people look at diversification the wrong way. They see something they own continually in the red and think they should sell it because it’s not doing well. We’ve added several holdings to our multi-asset funds, while hoping that we don’t see a profit from them for the foreseeable future. This sounds a bit silly, but it makes sense when you think of these assets as insurance. When you take out insurance, you always pray you won’t need to make a claim. The same holds with our portfolios.

When gilt yields broke through 1.50% for the 10-year, we started buying cautiously for our multi-asset portfolio funds. We had virtually none of these for a year or more because yields reached a point where we felt the value could only go lower. Now that yields have picked back up, we feel gilts are a better bet for portfolio protection. We expect yields to continue rising steadily, but we feel the losses this will incur should be relatively small and that will be more than offset by rising values in our equity investments. On the flip side, if there is turmoil in UK equity markets, gilts should rally, making us money.

Market risks come in very different forms and there is no one all-encompassing type of protection.  For example, gold can be a great diversifier against deflation, but not against rising interest rates in the US. Therefore it’s imperative that we have a range of assets providing protection against the highest probable future risks. Focusing on insuring against past risks can be expensive and fruitless: there’s no point only buying fire insurance if you live next to a river!

Another bit of insurance for our multi-asset portfolio funds: we recently bought a put option on the S&P 500 index, which will make money if the market falls below a certain level. If the US market continues to rise – as we expect – then this investment will lose value. But the cost of this option is small and it’s a sunk cost. We’ve paid our premium, which is just a fraction of a percentage of the fund, to protect ourselves against disaster.

If the market falls it would hurt many of our other investments, so we are not cheerleaders for a market correction. In fact, we’re optimistic about the economic situation for most of the world and the outlook for corporate profits. We feel there’s plenty of steam left in this business cycle’s boiler. But we aren’t psychic; we have no idea what will happen tomorrow. And given the extremely strong performance of equities over the past few years, we feel it’s prudent to be insured.