It is possible both to protect the value of your financial assets against downside risk and to earn higher average returns than you would on bank and building society deposits. The secret is portfolio insurance. That is the conclusion of David Blake of Birkbeck College, London, writing in the September 1996 issue of the Economic Journal. He argues that people would have to pay far less than they are actually prepared to in order to insure their portfolios. Unfortunately, no financial institutions are providing such insurance policies, a huge gap in the retail financial services market.
Blake notes that most individuals have an aversion to risk, that is, they are generally much more concerned about the value of their wealth falling than with it rising. As a result, they typically invest the bulk of their financial wealth in safe assets, such as bank and building society deposits, which retain their capital values over time. But while these deposits are safe, the returns on them are not very exciting, especially when market interest rates are as
low as they are at the moment.
However, it is possible to have the best of both worlds and invest in assets with much higher returns on average than deposits, and at the same time protect against the downside risk associated with these assets. The secret is portfolio insurance: you invest in a portfolio of risky assets and at the same time take out an insurance policy to protect against the downside risk. If at the end of the year, the value of your portfolio of financial assets is below the value at the start of the year, the insurance pays you the difference. Blake''s analysis of recent evidence from the Financial Research Survey clearly shows that people are highly risk averse in the UK. Very poor investors, the 25% of the population with financial assets worth between £50 and £450, would be prepared to pay an insurance premium of about 3% of their total wealth to avoid a fall in the value of their assets.
In contrast, very rich investors, the 1% of the population with financial assets above £36,800, would be prepared to pay more than 6% of their wealth to avoid a fall in the value of their assets. This is because rich investors hold a much larger proportion of their wealth in risky securities, such as shares and bonds, and so would be willing to pay a larger premium to insure their portfolios.
But the good news, according to Blake''s analysis, is that neither group of investors, rich or poor, would have to pay anywhere near as much as this to take out portfolio insurance. Blake shows that in a competitive market for portfolio insurance, very poor investors would have to pay a tiny 0.1% to insure their portfolios. This is because poor investors hold nearly 90% of their financial assets in safe deposits, and only 10% in riskier shares and bonds.
And rich investors, who hold 70% of their financial assets in shares and bonds and only 30% in deposits, would have to pay a portfolio insurance premium of less than 3% of their total wealth. Even after paying these premiums, investors would still end up getting much higher assured returns than if they put all their money on deposit.
So much for the good news. What about the bad news? The bad news is that there are no financial institutions around at the moment who are providing portfolio insurance. Blake has identified a big gap in the retail financial services market. Someone should come along and fill it!
''Efficiency, Risk Aversion and Portfolio Insurance: An Analysis of Financial Asset Portfolios Held by Investors in the United Kingdom'' by David Blake is published in the September 1996 issue of Economic Journal. Blake is Barclays Bank Reader in Financial Economics and Director of the Pensions Institute at Birkbeck College, University of London.