Risk Latte - Mark Twain's Cat and Portfolio Insurance

Mark Twain's Cat and Portfolio Insurance

Rahul Bhattacharya
Apr 30, 2006

Since our posting of the link on Portfolio Insurance and related articles/papers on the subject a few weeks ago we have received a lot of emails from visitors on this subject. It has only reinforced our belief that Portfolio Insurance and its immediate cousin, Constant Proportion Portfolio Insurance (CPPI), is very much back in vogue, not only amongst the sophisticated fund managers but also amongst academics and grad students. So here is another anecdotal piece on the subject.

In the aftermath of the 1987 stock market crash in the U.S. Burton Malkiel, author of the famous book A Random Walk Down the Wall Street likened portfolio insurers to the cat in Mark Twainˇ¦s aphorism. Twain observed that a cat that sits on a hot stove once will not do it a second time. Malkiel noted, quite brilliantly at that time, that the cat would not be inclined to sit on a cold stove either. And true to these words, the cat-portfolio insurance-did disappear, at least in the way it existed then, from the investors' repertoire of strategies completely.

However, though portfolio insurance become a hated word in the investing community, many investors kept on using derivatives to replicate synthetic put option strategies (bane of portfolio insurance) for more than a decade after the crash. Until in the early 2000 the cat came back again to sit on the stove. Portfolio Insurance is now back with a vengeance. Ask any fund manager and the first words that you might hear these days could be CPPI, a variant of portfolio insurance.

Reference: Taken from Financial Options-From Theory to Practice, Edited by Stephen Figlewski, William Silber, Marti Subrahmanyam and quoting from B. Malkiel, "The Brady Commission Report: A Critique" The Journal of Portfolio Management, Summer 1988.

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