The term “portfolio insurance” is used to refer to several different financial practices which are designed to insulate investors from financial risks associated with investment. The concept of portfolio insurance was developed in the late 1970s, and is believed to have played a role in the stock market crash of 1987, the infamous “Black Monday” in which global stock markets collapsed. Today, portfolio insurance is much less commonly used.
There are a number of ways in which insurers can protect themselves with portfolio insurance. One option involves selling index futures as stock prices drop, while retaining the stock itself. As prices continue to drop, the futures can be bought back at a lower price, generating a profit which reduces and limits loss. Portfolio insurance can be set up to do this automatically, ensuring that the response is rapid when pricing is highly volatile.
Another choice is to use put options, which give people the right to sell their stocks at a specific price. People are not required to exercise put options, but they can do so if prices are dropping and they feel that they should unload the stock before the price becomes even lower. In a simple example of how put options work, someone might buy at 100 units of whichever currency is being used, with a put option for 90. Whether the price of the stock is 200 units or 20 units, the buyer can opt to sell it at 90 with the put option. Thus, when prices drop, sellers can exercise the put option to get out of the investment with minimal loss.
People may also sometimes refer to brokerage insurance as portfolio insurance. In this case, a brokerage itself is insured against loss, protecting customers from losses when the market is volatile. This specialty insurance product is offered by various financial firms and insurance companies. These companies, in turn, spread the risk of their insurance product across a large pool to limit liability and hopefully avoid taking a loss if a payout is required.
Even with portfolio insurance, investing is risky. The riskier it is, the higher the potential rewards. This can be a problem for new investors who may think that they can make easy money, and realize that they are in trouble only after the market has started to decline. People who are interested in investing should consider taking classes and working with an investment consultant to learn the ropes before branching out on their own.