Dynamic Suicide

I just read Nassim Taleb´s new post on his Wilmott blog. As usual, his musings are quite enlightening and right to the point (Taleb never ceases to offer us truth). While it is difficult to doubt the academic prominence achieved by both Harry Markowitz and Marc Rubinstein, it is at the same time difficult to deny the doubts that surround the real-life validity of both portfolio theory and portfolio insurance. Few people have explained the shortcomings of both approaches as clearly as Taleb.

Inspired by his words, I began to think a little bit about portfolio insurance (2007, after all, marks the 20th anniversary of its crash-motivated downfall) and I reached what may seem like a naive (maybe even flat-out wrong!) conclusion: portfolio insurance was assisted suicide for those who contracted the service.

Portfolio insurance was an attempt to synthetically replicate a short put position via Black-Scholes-inspired dynamic hedging techniques. Thus, insurers (such as Rubinstein and his colleagues) would sell the underlying when the market fell and would have to buy when it rose. Assuming perfect liquidity and continuous trading, one could build a synthetic OTC put in this manner.

As the stock market embarked on a bull run at the beginning of the 80s (those “it´s morning in America” days), portfolio insurers would have been forced to follow the herd upward (Leland-Obrien-Rubisntein was established in 1981). As the size of the portfolio pool being dynamically “protected” grew significantly, the required buying would have become larger and larger. For instance, just prior to the October 87 meltdown, LOR alone was insuring in excess of $50 billion. In essence, it wouldn´t be far-fetched to argue that portfolio insurance provided a non-irrelevant push to the bullish market. Portfolio insurance could help cause a bubble. In fact, the bubbles supported by dynamic insurers would be of the worst kind: those where much of the buying is done for no fundamental reason at all, thus extremely crash-prone.

When the severe correction began to take place in mid-October 87, portfolio insurance helped drag the market to unknown depths (in terms of daily negative returns). Trading became illiquid and discontinuous and dynamic hedging inevitably broke down. Many “insured” parties ended up with no protection from the ensuing mayhem, victims of a nightmarishly unimaginable crash that was exacerbated by the very techniques that were supposed to help and which would never had taken place had the prior bubble not existed first, possibly impulsed by those same replicating techniques.

So, portfolio insurance may help create the bubble that causes the crash that prevents the insurance from working. Were customers committing inevitable suicide by joining the portfolio insurance bandwagon? Were they invitably doomed after signing on the dotted line? Did they provoke the actions that would ultimately sink them? Quite likely, yes.