When we take out insurance on our houses, our cars or ourselves, we do so to be protected against unlikely, but potentially catastrophic, outcomes.
We don't expect to make a profit on the transaction. We know that the insurance company should make money on average across the policies it writes. Indeed, we may choose to invest in insurance stocks for exactly this reason.
But when it comes to investment, many people take a different view. They buy insurance-like investments, such as put options, which give the owner the right to sell at a predetermined price at a set time in the future (thus allowing them to make money from falls in the market).
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While this is sometimes used to protect their portfolios, often it's with the aim of turning a profit. For example, if you'd bought a put option on oil at $75 per barrel a month ago, as some oil bears did, you're now sitting on a huge gain.
This kind of trade is immediately appealing: it dangles the prospect of a large profit for a modest outlay. But since we know that on average insurers turn a profit from all the people buying insurance policies, it raises a question.
Is buying options taking the right side of the trade? Is it instead likely to be more profitable, if duller, to be the writer of the option the insurer, in effect?
Why options are expensive
On this point, the evidence is "unambiguous", according to a paper by Antti Ilmanen of investment-management firm AQR.* He points out that the implied volatility priced into options on the S&P 500 index is almost always greater than the volatility that the market subsequently delivers.
In other words, people end up paying for a level of fluctuation in the market that almost never actually materialises. Put even more simply, it means that the options market just like the insurance market works to the benefit of sellers, not buyers.
This is entirely logical, says Ilmanen: options writers need to be rewarded for bearing risks, just like insurers are. On top of that, evidence from behavioural finance suggests that investors prefer investments with "lottery ticket"-like returns.
Investors are willing to pay more for potentially large, but unlikely returns, than they are for smaller, but more probable returns. This is a characteristic known as positive skewness. So investors can be expected to overpay for investments such as options which have this trait, meaning they are likely to produce low returns over time.
Another behavioural tic that reinforces this is our tendency to "crash-o-phobia". People are especially keen to protect themselves against the tail risk of a big crash. As a result, these types of options tend to be even more expensive, resulting in what's known as the volatility skew: options that pay off only in extreme situations have higher implied volatility.
The implication is straightforward, says Ilmanen. "Selling insurance and selling lottery tickets has delivered positive long-run rewards in a variety of investment contexts. Conversely, buying financial catastrophe insurance and holding speculative lottery-like investments has delivered poor long-run rewards."
It's not quite this simple
Case closed? Not at all, says Nassim Nicholas Taleb, the risk analyst, statistician and bestselling author. In a rebuttal to Ilmanen**, he took issue on a number of points. Some of these are quite technical, but his biggest criticisms can be broadly summed up by two caveats.
First, studies that imply that it's better to be a seller than a buyer of options and other forms of investment insurance tend to exclude extreme events, such as the crash of 1987, on the grounds that these are extreme events that are not typical of normal market conditions.
Yet, the reality is that these events not only happen, but they also happen more frequently than traditional finance theory would suggest.
Second, losses from selling investment insurance tend to have particularly unpleasant characteristics: they can be large, explosive and clustered in a short period of time.
So, even if selling insurance appears to be profitable over time on average, there is an increased risk of the seller being bankrupted by an unfortunate run of losses or from margin calls caused by a spike in volatility.
When the best move is not to play
Both of these arguments are compelling. On the one hand, options writers often take on more risk than they understand. The comparison to insurance companies is instructive.
Insurers usually have a large, well-diversified book of policies. They have the ability to select clients in way that helps them manage their exposure. They are a regulated industry subject to rules on the capital that they must hold against the risks they've insured. Options writers typically don't have these kinds of strengths to support their strategies.
On the other hand, buying options or holding investments with built-in insurance, such as capital-protected structured products, is likely to be alosing strategy. This is particularly truefor private investors, for whom suchproducts are normally overpriced.
We'd suggest that investors will usually be better off with other forms of protection. One of our favourites, for example, is diversification: you make sure that your portfolio holds a mix of assets that tend to behave differently under different conditions for example, gold often does well under conditions that might be bad for bonds, or equities.
And you should be cautious of investments that promise lottery-ticket-like returns, since these are frequently expensive relative to their chances of paying off.
*Do financial markets reward buying or selling insurance and lottery tickets?, Financial Analysts Journal, 2012.
** No, small probabilities are not "attractive to sell": a comment, fooledbyrandomness.com, 2013.
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