The investing term portfolio insurance refers to a trading strategy that attempts to reduce the downside risk associated with a collection of securities. Portfolio insurance techniques usually apply to a bundle of stocks, but can also be used for debt as well as derivatives. In practice today, the approach involves selling index futures short to protect against declines in the market.
The concept of portfolio insurance was developed to lower the risk associated with declining market values. The technique involves the programmatic movement of money invested in stocks into relatively safe investments such as treasury securities. In practice, this can be accomplished by selling index futures short.
The technique was popular among large institutional investors during volatile markets. When first developed in the early 1980s, program trading systems were in their infancy and moving out of a position by buying and selling large numbers of orders were both costly and complex. The speeds of today’s computers and communication networks have rendered portfolio insurance obsolete.
This trading strategy also declined in popularity following the Crash of 1987, when it failed to limit losses during that steep market decline. The programmatic selling of stocks to limit losses further depressed the price of securities as the number of sellers overwhelmed buyers. Sell orders didn’t settle at the target floor prices and declines were greater than anticipated, resulting in higher losses even for those with portfolio insurance.