Insurance costs money

Portfolio insurance, e.g., hedging, costs money.

Warren Buffett has said in the past that he'd prefer a company that can grow its earnings at an average, but lumpy, 12% per annum, compared to one that can grow its earning a smooth 10%.

That's because he's well aware that the compounding effect of the two rates over a long period of time will produce significantly different end values.

In a similar vein, I want to discuss the cost of portfolio insurance. This can be considered to be anything that smooths out the rate of return for the investor. For most of us retail folks, and for most brokers, this insurance comes in the form of inverse ETFs.

Inverse ETFs are usually bought when the market is trending downwards, and many brokers use some sort of technical signal, like when the 200 day moving average falls below some other shorter term average (notwithstanding that these signals no longer appear to work 1, 2).

If you accept the general premise that the stock market virtually always ends up higher after long periods of time, e.g. 10-20 years, then buying inverse ETFs can only have a adverse effect on your return rate over time, especially if they are bought midway through a downtrend. Inverse ETFs explain this themselves in their prospectus' and there are the trading costs themselves to also consider.

The problem is usually further exacerbated since most folks have no idea of how far the market is going to decline and, with all due respect to brokers and their technical signals, neither do they. Using a 200 day moving average as your sell signal, usually means that the market has already been drifting (or vomiting) downwards for some period of time, so you would be buying insurance when its utility is already lessened.

The only reason to buy it, is if it helps you stay in the market, and earn a long term average of 8%, as opposed to buying some other smoother, but inferior returning, investment vehicle.

Myself, I'd prefer a lumpy 9%, to a smooth 8%, thank you very much.

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