Individual investors: Asset allocation vs. portfolio insurance (puts or calls)

The purpose of this study is to test if an individual can successfully use index options to partially replace fixed income securities in an individual’s retirement portfolio. Two types of option insurance portfolios are examined. Put option insurance portfolios are created by selling fixed percentages of a stock index portfolio and using the proceeds to purchase index put options. Call option insurance portfolios are created by writing index options worth fixed percentages of a stock index portfolio and using the proceeds to purchase more of the stock index (covered call option insurance is also examined). The use of put options in the portfolio should allow the investor to reduce downside risk, as they age, similar to increasing the bond allocation, while also allowing the investor to participate in increased upside potential by having a higher percentage of the portfolio invested in stocks. Along with increased potential for returns with a larger percentage of the portfolio invested in stocks, the income the investor receives by writing call options and investing them in more of the stock index may also provide the investor some protection against losses in exchange for limiting potential gains. Results indicate that shifting asset allocation appears to be the better strategy when compared with the put option insurance portfolios. Overall the call option insurance portfolios returns are superior to the asset allocation portfolios. On a risk adjusted basis, an argument can be made that the fixed percentage call option insurance portfolios outperform the asset allocation portfolios, when the asset allocation favors stocks.