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"Reports of the death of mean reversion are premature" James Montier
Investment Strategy | 1 Comments | Mon 03 Jan 2011
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In August 2010 James Montier posted a very interesting article on his blog http://behaviouralinvesting.blogspot.com/ Originally this was written for the Financial Times, but deemed too technical by the editor. Below is an excerpt from it which focuses on the current market craze for protection and guaranteed products. Lets pose the question: Are guaranteed products a waste of money for investors as invariably investors will overpay for insurance over the life of the product?

The prudent investor should always pay attention to tail risk – the new normal doesn’t alter that.

Ever eager to please, the ‘engineers of innovation’ (or should that be the ‘architects of destruction’?) are happily creating products to serve the new bull market in tail risk. Deutsche Bank is launching a long equity volatility index, while Citi has come up with a tradeable crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Strangely enough, Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. Even the CBOE is planning a new index based on the skew in the S&P 500.

However, any consideration of the purchase of insurance should not be divorced from a discussion of the price of the insurance. Cheap insurance is wonderful, and clearly benefits portfolios in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand!

You should really only want insurance when it is cheap, as this is the time when no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset ... a path to the permanent impairment of capital. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves your dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffett said, holding cash is painful, but not as painful as doing something stupid!

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Comments

1.
On 14/02/2011 15:16:53, Anonymous wrote:
Ken French who with co-author Eugene F. Fama are well known for their research into the value effect and the three-factor model speaks in a brief video on this very subject. See link: http://www.dimensional.com/famafrench/2010/12/principal-guaranteed-products.html.html

To summarise: 'If my friends or my family asked should i buy one of these structured products, the short answer would be no.'

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