The Intelligent Allocator: the cost of hedging - a certain price for an uncertain payoff

Blaise Pascal, the 17th century mathematician and philosopher, once noted that humanity’s misfortunes were rooted in an “inability to sit quietly in a room alone.” An investor’s instinct to do something in the face of uncertainty– buy a put option, hedge, raise cash – is portfolio management’s equivalent tendency. Unless implemented with discipline, it can lead to potentially costly outcomes.

The instinct to act is not irrational, but it can be expensive, and this expense can go unnoticed. The cost of ‘rolling put protection’, an attempt to insure an equity portfolio against significant drawdowns, does not arrive as a single bill. It quietly erodes returns over a full cycle, compounding the opportunity cost.

If the two economists Myron Scholes and Fischer Black gave us the ability to price risk with mathematical elegance, another, Harry Markowitz, gave us the ability to diversify it away with mathematical simplicity. The options industry is built around the former, but portfolio foundations are built on the latter and deserve more attention.

An investor’s instinct to do something is not irrational, but it can be expensive

The instruments on offer

A put option gives its buyer the right, but not the obligation, to sell an asset at a predetermined price (the strike) before a predetermined date (the expiry). If the market price falls below the strike, the put gains in value, offsetting losses on the underlying position. If the market price stays flat or rises, the put expires worthless and the buyer forfeits the premium paid. The put buyer is, in effect, purchasing the right to sell in tomorrow’s market at yesterday’s price.

A protective put is the simplest application: the investor holds equities and buys a put on the same index or position. Losses are floored at the strike level; leaving upside participation. The cost is the premium, paid upfront or through regular rolling of contracts. It is comparable to an excess on an insurance policy: the lower the floor – or strike price – the cheaper the premium, but the more loss is absorbed before the protection is activated.

A 'zero cost put spread collar' attempts to solve this premium problem. The investor buys a put for downside protection, and sells a second put at a lower strike price that would only trigger if the market fell much further – to offset the cost – and simultaneously sells a call option above the current market level. The put spread provides protection within a corridor between the two put strikes, while the call premium offsets any remaining cost, bringing the net outlay to approximately zero. But the structure caps the upside (through the call) and the depth of the downside protection (via the sold lower put). If the market falls below the lower put strike, the investor is exposed again. What this strategy saves by eliminating the premium is paid for in both opportunity cost and the limits of the protection itself.

These instruments carry genuine advantages that allocation-based alternatives cannot replicate. They offer precision without liquidation: the investor stays 100% invested in equities, avoiding capital gains realisation and re-entry risk, where costs can be meaningful for tax-sensitive or concentrated portfolios. They also offer ‘convexity’ or a cushion against extreme market moves: in such rare, unexpected events, a put’s payoff accelerates as losses deepen. Cash and bonds are linear hedges, their protection scales proportionally with the allocation. A put option is non-linear – in the true catastrophe, it is the superior instrument.

Equity hedging instruments carry genuine advantages that allocation-based alternatives cannot replicate

They also offer control over timing. If a specific risk window is identifiable, options let an investor hedge that window and return to full participation in both the equity upside and downside afterwards, rather than permanently restructuring the portfolio.

Finally, they offer predictable payments because a put is contractual; if the market falls below the strike price, the put pays regardless. In contrast, bonds are an imperfect hedge whose diversification benefit depends on the day’s correlation between equities and fixed income.

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And their limitations

However, many investors believe that a put option provides a kind of financial alchemy, specifically that it removes risk from a portfolio in the way an insurance policy removes risk from a house. It does not. A put option reshapes risk by exchanging a potential drawdown for the certainty of a drag on returns. This cost comes in a form that most investors do not track: as a gradual lowering of portfolio performance. The volatility risk premium, or the fact that actual volatility is systematically lower than ‘implied volatility’, or the market’s forecast of future volatility, means that every rolling hedge will lose money over time. Insurance companies profit when premiums exceed expected claims. Options markets work the same way, except that its policyholders rarely do the arithmetic.

The asymmetry does not stop there. An options hedge requires a specific, identifiable risk to justify the premium. This may be an election, a central bank pivot, or a geopolitical flashpoint. Without one, the investor is paying a premium against a generalised anxiety with no expiry date. Rolling protection against an unspecified threat is not hedging but a monthly subscription to soothe unspecific fears. It also requires market timing, twice: when to put the hedge on and when to take it off. Enter too early and the hedging is a drag on performance. Enter too late and the investor buys protection at crisis-level implied volatility, which is the financial equivalent of purchasing home insurance during a storm. Both timing decisions must be roughly right.

An options hedge requires a specific, identifiable risk to justify the premium

Cash and diversification need neither a catalyst nor timing. Historically, a simple portfolio mix of 70% in equities and 30% in cash, short-term money market instruments or bonds has provided long term investors with hedging characteristics broadly comparable to those delivered by an option overlay. Such a '70/30' portfolio does not expire, does not need a catalyst, and does not ask the investor to predict which quarter will produce a drawdown. Diversification works quietly, constantly, and demands no forecasts.

The hedge without a Greek letter

We analysed four strategies and measured their behaviour across sixteen market crises between the Asian Financial Crisis in 1997 and President Trump’s announcement of Liberation Day tariffs in 2025 (see table 2 and chart 3). The results are uncomfortable for perpetual buyers of put protection. Over three decades, a simple diversified strategic asset allocation has produced similar downside protection to options-based strategies, at a fraction of the long-term cost.

A '70/30' portfolio does not expire, does not need a catalyst, and does not ask the investor to predict which quarter will produce a drawdown

This is a vindication of Markowitz’s portfolio diversification. Options are priced with extraordinary precision, but when the Black-Scholes model asks “What is the fair price of transferring this risk?” Markowitz answers “How do I build a portfolio that doesn’t need to know?” For an investor with a multi-decade horizon, the second question is the only one that matters.

Covid-19 and the case for put protection

The Covid-19 pandemic deserves special attention because it is the episode most responsible for reinforcing the case for put protection, although it is perversely the least representative. In early 2020, the S&P 500 fell 34% in less than five weeks, activating protective puts which delivered a drawdown of just –12%, compared to –25% for a diversified portfolio. It was a triumph for protective put strategies, and unusual. The crash was unusually sharp, unusually fast, and unusually concentrated in time. These are precisely the conditions under which puts perform best. For investors, this created a powerful bias.

The pattern should be familiar. Markets fall, volatility spikes, and investors – many of whom removed portfolio protection during calm markets when it was cheap – rush to buy put options at the worst moment. Following the first Covid-19 lockdown announcements, the VIX, a measure of S&P 500 volatility, was four-times higher than its long-term average, with premiums at crisis levels, and the protection barely offset its cumulative costs. The hedge was needed before the crisis, when it was cheap, and when most investors could not justify the expense.

To use an analogy, the alternative is not to find cheaper home insurance but to build a house less likely to catch fire. A portfolio built with true diversification across asset classes, geographies, and return drivers does not need a put option to survive a drawdown and does not ask the investor to time the next crisis. If a portfolio cannot survive a drawdown without options, the problem is not the lack of a hedge, but its underlying strategic asset allocation.

No portfolio instrument can turn risk into safety without a cost. But investors can construct a '70/30' portfolio designed to resist a crisis, rather than shop for protection in the middle of one. That demands the discipline to resist doing something in the face of uncertainty – the instinct Pascal warned against – and trusting that a well-constructed portfolio is, itself, the hedge.

Investors can construct a portfolio designed to resist a crisis, rather than shop for protection in the middle of one

This paper addresses the classic strategies available to private investors, including listed puts, collars, cash allocation, and traditional portfolio diversification. The institutional investor universe is broader, and hedge fund managers operate with a more flexible toolbox. This is, in part, why we favour a strategic allocation to hedge funds within a diversified portfolio.

This offers risk management techniques that are impractical to replicate through listed options or static asset allocations alone. Such strategies tend to demonstrate their value when traditional hedging disappoints. But for the long-term allocator working with the instruments available, the conclusion is the same. The ‘Intelligent Allocator’ does not need a form of generalised insurance but discipline and the willingness to sit still.