Contingent Immunization for Equities

There are, as you know, 3 approaches to investing:

Active, Semi-Active, Passive

Somewhere in the CFA Program we covered a topic called contingent immunization, which is a semi-active strategy for bond portfolios.

What amazed me about contingent immunization is how totally different the approach is versus what you’d do if you were implementing semi-active for stocks.

With stocks, “active” implies hand-picking companies, “passive” implies indexing. Semi-active means doing something like indexing 90% of the portfolio and hand-picking the other 10%. That’s about as brave as my bungee jump from a 7-story tower back in the 90s… which I only agreed to do because they had an air bag on the ground underneath in case something went wrong.

Bungee Adrenaline
Semi Adrenaline Junkie

But I learned with contingent immunization that there’s another way to play semi-active. You can take off right out of the gate 100% full afterburner active with your hair on fire… but hit the eject button if the wings start coming off.

It’s really as simple as that. Say your benchmark is the S&P 500.

1. Start the year 100% active in 20 or so stocks you've hand-picked.
2. Monitor daily your YTD return vs. the S&P 500.
3. If a serious lag starts developing (e.g. -5%) sell all and switch to 100% index for the rest of the year.
4. Otherwise, let it ride...

Here’s an example I spreadsheeted.

Contingent Immunization for Stocks

I should note that just because your trigger point is, say -5%, that doesn’t mean you end the year at exactly a 5% lag if you have to bail. Play with it in a spreadsheet to see how it works. If the index moves up or down hugely after you bail, you might do a couple % better or worse than 5%.

But I think you get the picture. For the distribution of our yearly returns, we want to avoid the left tail of this…

100% Active
100% Active

But we certainly want something more exciting than this…

90% Index, 10% Active

And I think this contingent immunization plan for equities might give us this…

contingent immunization
100% Active to begin with. Switch to 100% Indexing if things start falling apart.

What have I missed?