Portfolio insurance strategies aim to limit losses in investment portfolios while still capturing some upside. Constant proportion portfolio insurance (CPPI) is a dynamic approach that adjusts asset allocation between risky and stable assets based on portfolio value. When values go down, it moves more money into safer places so your total portfolio doesn’t fall too far. Ask a financial advisor whether portfolio insurance is appropriate for your risk appetite and time horizon.
How Portfolio Insurance Works
Portfolio insurance is a term for a set of strategies that investors use to try to give their portfolios some protection from losses. Here are some of the approaches they employ:
All these strategies aim to control risk and lock in profits. They can also help investors stick to long-term plans and avoid making emotion-driven choices in volatile markets.
Why Portfolio Insurance Helps
For regular investors, portfolio insurance provides some key benefits:
- Downside cushioning. At the same time, it lets you capture some upswings
- Avoiding panicked selling. This can be invaluable when bear markets hit.
- Investments always match your risk comfort zone. Otherwise, shifting values of assets in your portfolio over time can create a mis-match.
A key underlying assumption is that by limiting losses, insurance helps investors stick to financial plans. This assists in growing wealth over time.
How CPPI Works
CPPI sounds complicated and executing it requires care and attention to detail. To get started, however, you only need to choose two things – a portfolio floor and a multiplier.
The floor is the minimum value you want, expressed in dollars and usually based on your risk tolerance. It is the lowest level to which you want your portfolio’s total value to sink before you take protective action.
The multiplier tells CPPI how to split money above that floor between risky and stable types of assets. It provides a guide to help you make asset allocation decisions.
The floor and the multiplier work together. When values decline to the floor level, CPPI automatically shifts holdings from risky to stable assets, using the multiplier to guide purchases and sales.
For example, say your portfolio is $100,000. You choose an $80,000 floor and a 2x multiplier. That initially allocates $40,000 (2 x ($100,000 – $80,000)) to stocks. If values drop to $90,000, the stock portion changes to $20,000 (2 x ($90,000 – $80,000)).
A CPPI Example
An example may help explain how this works. Imagine that you have $120,000 to invest. You want no less than $80,000 there for stability. You choose a 2x multiplier so more money goes to stocks, where you have greater potential for growth.
First, 2 x ($120,000 – $80,000) = $80,000. So, you buy $80,000 worth of stocks. The remaining $20,000 goes into bonds.
Now say that stocks decline and your portfolio sinks to $100,000. In this case, you will increase the amount of your portfolio invested in bonds. The new split is 2 x ($100,000 – $80,000) = $40,000 in stocks. The remaining $40,000 goes into bonds and cash to help defend your $80,000 floor.
CPPI is widely used but not without some limitations and imperfections. While CPPI aims to protect against falling markets, know that:
- It takes sophisticated financial modeling to do it well
- Sudden crashes can mean floors fail
- Shifting money constantly generates commissions and other transaction fees
- Capping risky assets helps limit losses but also can limit possible gains
Before choosing to use CPPI, try to understand exactly how much risk remains and what returns you might achieve. For some investors, portfolio insurance is not worth the time, effort and cost, including the potential cost of missing out on gains.
CPPI moves your holdings between stocks and stable assets automatically to cushion declines. It maintains a value floor by buying safer investments when markets sink. But CPPI is complex, incurs costs for rebalancing and could restrict your portfolio’s upside. Research thoroughly so you know what you’re getting and whether it fits your strategy.
Investment Planning Tips
- Ask an advisor to model CPPI with your actual portfolio and see if it would limit your losses while meeting your need for return. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Take a look at SmartAsset’s Investment Return and Growth Calculator to see how your portfolio may increase in value over time.
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