Discover a stock allocation strategy with downside protection and leverage of gains – 11/17/2023 – From Grão to Grão

As described by Nobel laureate William Sharpe, there are three basic strategies for allocating your portfolio to risk. If one of them adopts behavior with the evolution of market prices. In yesterday’s article, I explained the two most well-known ones. Today, I explain the third.

The three allocation strategies are:
I – Buy and Hold (Buy and maintain);
II – Constant Mix (constant weights);
III – Constant proportion portfolio insurance (portfolio insurance).

The first two are the best known, but both are particular cases of the third. This one is a little more complex.

Each of these strategies determines the investor’s behavior regarding the evolution of the stock market. There are three possible attitudes: buy, sell and do nothing.

Before explaining how the third strategy works. Consider that the three strategies start with an allocation of 30% in stocks and 70% in fixed income. I will describe the behavior of each of them in the following rebalancing period, depending on what happens with the market:
I – Buy and Hold: Investor does nothing whether the stock market is rising or falling;
II – Constant Mix: Investor buys more shares when the share price falls and sells when the price rises;
III – Constant proportion portfolio insurance (CPPI): Investor sells more shares when the share price falls and buys when the price rises.

In each strategy, the investor adopts a different attitude. The behavior recommended in the third strategy, the CPPI, is not what we are used to hearing. So, let’s understand it.

In strategy CPPIthe definition of allocation in shares at each rebalancing moment is defined by the formula: Allocation = m * (Asset Value – Assured Value), where:
– “m” is a multiplier that must be greater than 1 and defines the allocation intensity;
– “Asset Value” is the sum of the allocation in fixed income and shares;
– “Assured Value” is the minimum amount you accept that your portfolio will fall.

Realize that the worst outcome is for the portfolio to drop to the “Assured Value”. Therefore, the name of this strategy Portfolio Insurance (Portfolio Insurance in English), as you your portfolio will never fall below this defined value.

The insured value must be corrected by the fixed income. This way, you have a minimum that is always up to date.

The difference between the Asset Value and the Insured Value can be considered as your risk cushion on which you apply a multiplier to define the risk you want to take.

The third strategy has a convex outcome curve. This means that as the market rises, you earn at increasing marginal rates. And as the market falls, you lose at decreasing marginal rates. Simply put, you accelerate the gain on the way up and slow the loss on the way down.

If the market continues in a trend, whether upward or downward, the strategy CPPI is the one that gives the best result.

If the market continues to rise, you buy and take advantage of the market gains with greater exposure. When the market is on a downward trend, you systematically reduce your weight in shares and are less exposed in the next drop.

Have you ever heard of the author of The Logic of the Black Swan? Renowned author Nassim Nicholas Taleb often suggests strategies that involve convex outcomes such as CPPI.

Convex strategies are those that allow you to win exponentially and on the downside, lose in a way that does not put you at risk of ruin.

The opposite occurs with the strategy Constant Mix.

The strategy Constant Mix has a concave result curve. This means that as the market rises, you earn at decreasing marginal rates as you sell. And as the market falls, you lose at increasing marginal rates, because as the market falls, you buy.

The strategy Buy and Hold has a linear results curve.

In a future article, I will illustrate the use of each of them and show in a spreadsheet how the first two strategies are particular cases of the strategy CPPIjust changing the terms of its formula.

Michael Viriato is an investment advisor and founding partner of Investor’s House.

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