What is CPPI and why should you care?

CPPI, or Constant Proportion Portfolio Insurance, is an investment strategy whose goal is to allow investment in risky assets (like stocks) while still guaranteeing a minimum level of capital at the end.

It helps you decide how much to put into risky assets and how much to keep safe. It does this dynamically, increasing your risky investments when things look good and reducing them when the market looks shaky.

CPPI was introduced to the investment world by Fischer Black and Robert Jones in 1987.

How CPPI Works

Let's say you have $100 today, and you absolutely need to have at least $100 in ten years for a specific project. How much of that money can you risk for a chance at higher gains in the meantime?

CPPI works by balancing your investments between two components:

1. Cushion

This is the amount of money you can afford to risk, calculated as the difference between your total wealth and the floor (the minimum amount you want to safeguard).

A formula to calculate the Floor is:

$$Floor (today) = Target Wealth \times (1 + Safe Asset Rate)^{-N}$$

where N is the number of remaining rebalancing periods.

Example: If your total wealth is $100 and your floor is $76, your cushion is $24

By allocating $76 to the safe asset earning a 2.8% annual return, you can ensure reaching $100 at the end of 10 years, regardless of market conditions.

2. Multiplier

The multiplier is a predetermined number that you multiply the cushion by to determine your exposure to the risky asset. It, therefore, dictates how aggressively you allocate your cushion to risky assets.

Example: With a multiplier of 3, you’ll invest three times your cushion ($24 × 3 = $72) in risky assets, while the rest ($28) remains in bonds.

Why does this work?

You can invest more than your cushion in risky assets because extreme losses in a short time are rare. If such a loss occurs, the CPPI mechanism will reallocate your remaining wealth to the safe asset, preserving your floor.

In essence, the multiplier reflects how much risk you are willing to take:

• A multiplier of 3x means you can withstand a 33% drop in risky assets.
• A 4x multiplier allows for a 25% drop, and so on.

By adjusting the multiplier, CPPI allows you to tailor your strategy based on your risk tolerance while maintaining a built-in safety mechanism.

Pros and Cons

Pros of CPPI

• Downside Protection: Keeps a portion of your money in safe assets, limiting losses.
• Upside Potential: Lets you benefit from good market conditions by increasing risky investments.

Cons of CPPI

• Missed Opportunities: If the market soars, CPPI may underperform compared to an all-risky portfolio.
• Complex Rules: It requires some setup and understanding compared to simpler strategies.
• Costs of Rebalancing: Frequent adjustments might incur transaction fees, depending on your investment platform.

CPPI lets you blend different assets to match your goals.

Safe assets offer protection, risky assets chase growth, and CPPI dynamically balances between them for a customized approach.

How We Built the Simulations

To better understand how CPPI works, we conducted a series of simulations using the following assumptions and parameters:

1. Theoretical Safe Asset: We used a hypothetical safe asset with a fixed annual return of 2.8%, which remains constant over time.
2. S&P 500 Nominal Returns: For the risky asset, we used the actual nominal returns of the S&P 500 index from January 1928 to December 2023. This approach ensures our simulations reflect historical market conditions, including periods of both high volatility and steady growth.
3. Initial Wealth: Each simulation starts with an initial wealth of 100, and the primary objective is to ensure that the final wealth at the end of the investment period is at least 100.
4. Quarterly Rebalancing: Portfolios are rebalanced every three months to adjust the allocation between the safe and risky assets, ensuring alignment with the cushion and floor calculations.
5. Floor Calculation: At the end of each rebalancing period, the floor—the minimum wealth to preserve—is recalculated. The floor is determined by compounding the target final wealth (100) back to the current period.
6. Interest Payments: The interest from the safe asset is paid at the end of each rebalancing period and reinvested accordingly, contributing to portfolio growth.
7. No Leverage: To keep the simulations straightforward, we assume no debt or leverage is used. This means that even if the risky asset performs exceptionally well, the total investment in risky assets is capped at the current wealth. (Some variations of CPPI allow leverage in such cases, but we chose not to include it.)

100,000 Simulations

We ran simulations spanning January 1928 to December 2023, covering a wide range of market conditions. Each simulation involved:

• Investment Durations: From 1 year to 20 years.
• Multipliers: Ranging from 1x to 5x.

For each combination of investment duration and multiplier, we ran simulations starting on the first day of every month. For instance:

• Period 1: January 1, 1928, to January 1, 1938 (for a 10-year duration).
• Period 2: February 1, 1928, to February 1, 1938.

This process was repeated for all possible combinations, resulting in more than 100,000 simulations. Such a comprehensive dataset allows us to evaluate how CPPI performs across various market conditions, including bull, bear, and flat markets.

Now that you know what CPPI is and how it works, why not explore if it’s right for you? CPPI might just be the strategy that protects your money while still giving you a shot at growth.

Remember: CPPI is just one of many strategies. Always choose the one that aligns with your financial goals and risk tolerance.