Every now and then I run into an old college buddy and the first question asked is: What have you been up to?

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E very now and then I run into an old college buddy and the first question asked is: What have you been up to?

If I really wish to terrorize the guy I’ll say, I am selling insurance.

Today I want to sell you some portfolio insurance. Portfolio insurance is basically a form of term insurance that never asks for your age or your medical history. The beneficiary is your portfolio and you’re never questioned on motive or insurable interest.

Portfolio insurance is a valuable tool for any investor who has most of their investable assets in the equity markets because it will provide some degree of protection if the markets tumble.

In the old days, investors and advisers would adopt two strategies. If we had a time horizon of at least three years, we would do nothing and wait out the correction. The aggressive strategy would be to time the market and dispose of the stocks when the markets looked overextended

There are problems with both approaches. The do-nothing approach could have you fully invested through a peak-to-trough and back-to-peak cycle that could span several months, generating no returns. The timing approach of selling all and buying back later at lower prices could backfire if the markets do not correct.

We never want to commit the No. 1 sin of investing: being in cash when the market is rising.

Applying portfolio insurance is easy if your equity investments resemble a portfolio. If you are a stock picker, start by selecting only components from the S&P/TSX60. You would buy two banks, one life insurance company, two energy firms, two miners, one industrial firm, one consumer, one utility, one technology and one telecom company. You’ll have 12 stocks and a diversified portfolio. All you have to do is rebalance once or twice a year.

If you wish to simplify your monthly statement, just buy the TSX-listed iShares CDN S&P/TSX 60 Index Fund (XIU) and you own the entire S&P/TSX60. With a single purchase you have become the manager of an index fund.

Now we need the appropriate insurance strategy. I would rule out using options because of their cost and poor liquidity.

One could defend buying index puts, which rise when the stock goes down, but the other strategy of covered callwriting makes no sense at all. When you adopt a covered callwriting strategy you get a few bucks and in return you give away any upside potential.

Our chart this week is weekly closes of the XIU plotted above those of the TSX-listed Horizons BetaPro S&P/TSX 60 Bear Plus Exchange Traded Fund. Note the inverse relationship.

According to Horizons BetaPro Management Inc. the Bear Plus funds are designed to offer double the daily performance opposite that of the underlying index or commodity. In other words, we have an investment product that is structured to operate in the opposite direction to the portfolio.

This is important because a portfolio manager will often place assets inside the portfolio that will have a negative correlation with the broader equity markets. This serves to reduce the volatility of the overall portfolio.

The math works like this: If we assume a 15 per cent correction, a portfolio weight of only 10 per cent in the bear HXD will limit the portfolio to a 10 per cent loss. If we are wrong and the market runs up another 15 per cent, we only give away 4.5 per cent of the upside.

Unlike options, the bear fund is very liquid, trading about 2 million shares per day and so we can cancel the insurance at any time by selling. The gains or losses are returned to the portfolio and we survive to fight another day.

Bill Carrigan is an independent stock-market analyst. He can be reached at www.gettingtechnical.com .