October 19, 2008
Regulatory Rule #3: Don’t Rely on the Sophistication of Sophisticated Investors
Posted by Mike Guttentag

Economists now recognize the pivotal role that portfolio insurance played in the 1987 stock market crash.  An obvious follow up question is rarely asked:  did it make sense for institutions to “purchase” portfolio insurance in the first place?  Why is this question left unaddressed?  Because portfolio insurance is an entirely rational strategy, given a certain set of preferences, and economists abhor examining the “correctness” of preferences, no matter how odd the preferences may be.  A regulator responsible for overseeing financial markets does not have that luxury.


Portfolio insurance was a surprisingly popular product.  Multitudes of institutional investors liked the idea of locking in their gains.  For such an investor, being fully invested in equities when the Dow was at 2,200 was all the better if you were completely out of the market when the Dow was at 1,700.   But does such a contingent attitude toward holding risky assets actually make sense for the typical institutional investor?  Why treat holding equities like Giffen’s potatoes during a potato famine?


The answer: it was almost certainly illogical, from a long-term investment perspective, for an institutional investor to “buy” portfolio insurance.  To reach this conclusion one needs to look into the black box of preferences.  A comparison with the current subprime crisis is particularly illustrative here.  Most agree that one cause of our current crisis was the practice of purchasing a home by putting little or no money down.  People who purchased homes in this way have been criticized for taking on risk that they could not justify.  Compared to the institutional investor who chooses to purchase portfolio insurance, the no-money down home purchaser looks remarkably sane.  The no-money down home purchase is similar in payoff to the purchase of portfolio insurance.  If home prices rise, the no-money down purchaser owns a house.  On the other hand, if home prices fall, there is a forced put and the bank owns the house.   For someone purchasing a home with no money down, the rewards may be worth the risk.  But for the institutional investor, whether prices go up or down, the institutional investor is still going to be managing a portfolio of assets.  What reasonable long-term investor would want their exposure to risky assets dependent on whether the Dow is at 1,700 or 2,200 on a particular day?


There are, of course, explanations as to why institutional investor purchased portfolio insurance, despite the fact that it was not consistent with sound long term investment practices.  The institutional investor might be worried that he/she would lose his/her job, unless he/she was fully divested if the market went down.  Or perhaps his/her decisions were strongly affected by an endowment effect, leading him/her to treat recent gains as especially valuable.  Perhaps the investor thought the market was overvalued, but did not want to be left behind if it proved to be the case that he/she was incorrect.  Whatever the rationale, the preferences which led to the 1987 crash are difficult to justify based on any rational investment strategy.

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