Portfolio Management: An Alternative to Insurance
There was a very cautious man
Who never laughed or played
He never risked, he never tried,
He never sang or prayed.
And when he one day passed away,
His insurance was denied,
For since he never really lived,
They claimed he never really died.
Okay, to begin with, I have to say the poem is nothing to do with what we will be talking about, this was just enough to break the ice.
Robert Shiller stated, Portfolio Management is an alternative to Insurance.
The basic idea about insurance or getting insured to minimize the losses incurred in case of happening of an uncertain event.
A portfolio is pretty much the same idea, it is the diversification of ownership. It’s an idea of managing risk not through purchasing of insurance policy, but through diversification (owning a variety of asset).
A risk is inherent in investing, thus we diversify the investment by buying different assets and not putting “all our eggs in one basket”. I guess you have heard a lot of times about that phrase, but I like the history of thought, so I tried to find out when was this phrase used at the earliest, the best I could find that it itself was used by Alexander Crump in 1874, in his book on how to invest, where he wrote, “It is an old saying that is unwise to put all your eggs in one basket”.
A later insight –
If all people are like me, thinking the same thing and trying to hold the same kind of portfolio, then still why is it different from one person to another? The core insight of the theory is, you know what, even if I calculate the optimal portfolio, the best-diversified portfolio, then how is it different from others?
Well, you could be different from others because you might be more risk-averse than others. You might have a greater or lesser risk tolerance. But that tolerance to risk could be adjusted by leveraging your portfolio up and down.
I have a rather interesting explanation for leverage though! So a lever is something used to move things, and leverage is how you move people. Imagine, if I was in need of money, and then I go to a bank for a loan, then the bank will have leverage over me and the will charge me with high-interest rates. Similarly, before 2010 when there was no Obamacare policy in the US, only people who were sick or who knew they were going to be sick, bought health insurance and thus the insurers had leverage over them and they charged high rates. Same is with your portfolio, you get leverage over the risk. If you are a rational economic person, you will have portfolio management so that you don’t have to worry about a stock going down, it’s the total that matters to you.
Conclusively, if we compare portfolio management and insurance it’s basically the same idea to minimize the risk. Investors do it by diversification, and insurance companies do it with what they call as risk-pooling, where insurance companies come together to form a pool, which can provide protection to insurance companies against catastrophic risks such as floods or earthquakes.