Taming the human element

Markets have always been driven by greed and fear. However, recent advances in financial computation have bordered on the verge of taming the human element. Many observers believe that the severity of the 1987 stock market crash was due, in large part, to the use of an option-replication strategy known as portfolio insurance. The near-collapse of Long-Term Capital Management exemplified similar problems as its trading activities added to overall market volatility leading to price movements against its own strategies. Both Bruce Jacobs and Nobel laureate Harry Markowitz, who has written a foreword to Jacobs's book, confirm this view.

The book explores the procedures and rationale of portfolio insurance, its effect on the market and its suitability for the investor. Jacobs examines how some investment strategies, "can self-destruct, taking markets down with them". Portfolio insurance ironically fails to live up to its name as there is no pool of assets an insurance provider can draw upon to reimburse client losses. Insured investors bear that risk themselves.

Jacobs offers alternate methods of investing to achieve objectives similar to portfolio insurance without its inherent shortcomings. Portfolio insurance tends to destabilise the market because it advocates mechanistic buying when stock prices rise and selling when prices decline. When a large number of investors engage in this type of "dynamic hedging" their trading activities exacerbate market volatility. As Markowitz explains, "the objective of portfolio insurance is to reduce risk, in some sense, perhaps at the expense of return on the average. This sounds very much like the objectives of portfolio theory's mean-variance analysis. The objective of the latter is to present the investor with 'efficient' combinations of risk and return from which the investor picks an efficient combination according to her or his risk aversion, perhaps sacrificing return on the average in order to reduce risk."

The book is in four parts. Part one deals with options and option replication and synthetic portfolio insurance, highlighting its implementation pitfalls. Part two deals with the crash of 1987 and examines the non-fundamental factors that brought about the massive liquidity crisis. Part three examines how insurance trading combined with futures and index arbitrage can create a potentially lethal combination as the hidden price of synthetic insurance obscures the extent of the strategy's use, thereby sending misleading signals to market participants. Part four examines the mini-crashes of 1989, 1991 and 1997 as well as the problems surrounding Long-Term Capital. Historical evidence indicates that short-term losses in equity values have been offset by gains over the long term. Prudent investors can maximise return and minimise risk by relying on diversification over time and assets rather than resorting to short-term trading decisions that boomerang.

The high valuation of the US market, a shift towards indexation among pension fund managers in the UK and the use of derivatives in market-neutral strategies are all gaining importance in Europe as governments and pension fund providers cope with the demographic time-bomb.The presence of US firms in Europe and the lacklustre performance of value managers across the globe, have fuelled the rise of passive investment strategies. As derivatives are here to stay, it is important for investors to understand the consequences of their trading decisions. While European fund managers have been suspicious of the use of such instruments after the collapse of Barings Bank in 1995, derivatives have their uses in altering the risk-reward profile of a portfolio.

Understanding the limitation of certain trading strategies is critical to making an informed investment decision. This book is therefore relevant to all investors, traders, arbitragers, trustees of pension funds, consultants and private client managers.

Shanta Acharya is an investment consultant and author of Investing in India .