Adjustment Discipline for Portfolio Insurance: Trade-off and Choics

Abstract

The main characteristic of portfolio insurance is to provide downside protection for the value of a risky portfolio while preserving much of the upside potential. In order to generate the attractive feature of option-like payoff, the general principle of these strategies is to increase the size of risky assets in an up market and decrease in a down market. In the presence of transaction costs, however, the dynamic adjustment process becomes inefficiency, especially in whipsaw markets. These difficulties can be controlled by appropriate selection of adjustment discipline. The purpose of this paper is to evaluate and compare the performance of alternative portfolio insurance strategies associated with different adjustment disciplines in terms of their hedging effectiveness against the costs involved. We seek to discover which of the various approaches of implementing portfolio insurance is the most advantageous. The study is conducted in two parts. First, we employ the Monte Carlo simulation to investigate the cost/benefit potential of alternative approaches to portfolio insurance. Then, we examine how portfolio insurance strategies might have worked in domestic financial environments between January 1985 and December 1990. The results show no single approach can outperform the others in all cases. However, the technical analysis aided adjustment discipline designed in this study does perform best in most of the cases.