Protecting the Downside, while Participating in the Upside

Protecting the Downside, while Participating in the Upside 
 A couple of months ago in “Lifecycle investing” I, superficially touched, upon Zvi Bodie’s view that diversification is not the only way to reduce investment/market risk. In fact, according to him, it may not even be the best way. In a reference that I quote in that blog, “Retirement investing: A new approach” , one of his conclusions is that “… sponsors of self-directed investment plans can enhance the risk-reward opportunities available to investors by offering option like securities or contracts as an additional asset class. These assets can provide a means of leveraging participation in stock market gains while protecting one’s minimum standard of living.” Specifically, he suggests that if you have $1,000,000 you may consider taking 90% and putting it in risk-free bonds and 10% into longer term calls (LEAPS) on the index whose upside you want to participate in.
My last week’s blog on Nassim Taleb’s “The Black Swan” , I mentioned that Taleb advocated in a manner analogous to Bodie, that the best way to get downside protection and still participate in the upside is to invest 85-90% of one’s assets into risk-free instruments and put the balance in highest-risk/highest-return investment vehicles.
Let’s see what it would look like if we implemented Bodie’s model. One could do this with a basket of LEAPS, but I happened to have chosen calls on the ishares S&P/TSX60 index, XIU on the TSE. XIU was trading at about $81 on July 4, 2007, while March 2009 calls on XIU, with $81 strike price (I averaged the bid/ask prices on the $80 and $82 calls) were priced at about $9.10. The 21 month (to March 2009) risk-free rate was about 4.6%. Therefore for the $100 portfolio we invest $90 into 4.6% government issue 21 month strips and for the remaining $10 we buy approximately 1.1 calls at $9.10 each. So let’s see what the various investment approaches leads us to in terms of risk. I calculated and plotted three competing options: (1) 100% stock, (2) 50% stock and 50% bonds and (3) the Bodie portfolio of 90% bond and 10% calls (LEAPS). I also included the 100% bond scenario as the opportunity cost, where all outcomes are about $108.
Observe that we started with the $100 portfolio and stock XIU=$81. On the downside when XIU=$40 (down about 50%) the 100% and 50% stock portfolios are down about 51% ($49) and 21% ($79) respectively. The Bodie portfolio is down less than 3%. So the downside is protected.
Now let’s see what happens if XIU=$120 (up about 50%). The 100% and 50% stock portfolios are up about 48% ($148) and 28% ($128), respectively, while the Bodie portfolio is up 40% ($140)! So we captured over 80% of the upside provided by the 100% stock portfolio and handily beat the 50% ($128) stock portfolio.
The only apparent disadvantage, disregarding possible tax consideration of higher bond income and having to pay tax on LEAPS profits when they mature, is that between XIU values of about 70 and 90(i.e. an annual return of about +/- 12% which, for the U.S. market, occurs about 40% of the time), the 50:50 stock: bond portfolio underperforms the Bodie portfolio by between about 0-5%.
All in all, the Bodie portfolio may be worth an extra look for a retiree wanting to protect the downside and still participate in the upside.

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