Portfolio insurance with ratcheted floor as a long-term asset management strategy: implications of loss aversion

Abstract

The existing literature has revealed that the performance of current portfolio insurance strategies as long-term asset management is limited. Prospect theory implies that creation of ladder return distributions by portfolio insurance can improve long-term asset management with criteria of loss avoidance and gain protection. Based on this principle, we propose the Ratcheted Floor Variable Proportion Portfolio Insurance (RF-VPPI) as a competing strategy with the Constant Proportion Portfolio Insurance (CPPI) and rolling-CPPI strategies. Simulations and empirical tests demonstrate that the RF-VPPI outperforms the CPPI and the rolling-CPPI in the long term.

Acknowledgements

The authors would like to thank the Editor Professor Mark Taylor for his extremely helpful comments. The second author would like to thank the National Science Council Taiwan for financial support (NSC 98-2410-H-035-016).

Notes

¹The CPPI stipulates that its floor increases at a risk-free rate. As the risk-free rate is relatively smaller than the changes of asset prices, the CPPI can be treated as a proxy of fixed-floor portfolio insurance.

²People usually set a fixed percentage (e.g. 20%) of wealth as the tolerance for conducting portfolio insurance and rebalance their floor accordingly. As the final wealth reflects the current asset price that is dynamic, the rolling-CPPI rebalances its floor randomly.

³See Lee et al. (2008) for the detailed proof.