Should You Buy Portfolio Insurance to Protect Against a Stock Market Crash?

A member of my investing community recently asked whether investors should hedge and spend 1% to 2% of their portfolio every year buying insurance against a stock market crash.

My short answer: Generally, no.

Portfolio insurance, including protective put options, can reduce losses during market crashes. But paying for that protection year after year can significantly reduce long-term investment returns.

Instead, I prefer to protect my portfolio by owning resilient businesses that can create substantial value over time, avoiding excessive valuations, regularly reassessing my investments, and maintaining enough liquidity to navigate difficult markets.

That doesn't mean hedging never makes sense. Successful investors like Ray Dalio and Paul Tudor Jones have emphasized the importance of managing downside risk. I agree with the objective, even if my approach is different.

Let me explain why.

What Kind of Game Do You Want to Play?

Before discussing put options, hedging strategies, or predictions about the next stock market crash, I think there's a more fundamental question worth asking.

What kind of life do you want to live? And where do you want to direct your time, attention, and energy?

Personally, I prefer spending my life playing positive-sum games rather than zero-sum games.

A zero-sum game is one where one person's financial gain comes at another person's expense.

Think about trading options. At the level of the derivative contract, one party's trading gain is generally offset by another party's loss, before transaction costs.

But now think about what happens when you own a great business.

Imagine a company that develops a better product, makes life easier for millions of customers, treats its employees well, and generates tremendous cash flow for its shareholders.

Who wins?

The customers win because they're receiving something valuable. The employees can win because the business creates employment and opportunities. And shareholders can win because the company becomes substantially more valuable.

There doesn't have to be a loser.

That's an enormously appealing proposition to me.

And it's why I spend so much of my time asking a very different question from the one that drives much of Wall Street.

Why could this business be worth multiples of its current value in five or ten years?

I find that question infinitely more interesting than trying to predict whether the stock market will fall 20% next quarter.

Of course, options aren't inherently bad. A hedger and someone willing to absorb that risk can both benefit from the arrangement, even if the financial contract itself is zero-sum before costs.

I'm simply saying that it's not where I personally want to devote most of my energy.

What Is Portfolio Insurance, and Does It Actually Work?

Portfolio insurance generally refers to strategies designed to offset investment losses when markets fall.

One common example is buying put options on the S&P 500.

A put option gives you the right to sell at a predetermined price, providing potential protection if the underlying index falls below that price.

If the market crashes, your puts may become substantially more valuable and offset some of your portfolio's losses.

So yes, portfolio insurance can absolutely work.

The challenge is that protection comes at a cost.

Imagine you have a $1 million portfolio and decide to spend 1% to 2% of your portfolio value annually on protection.

That's $10,000 to $20,000 in the first year alone.

If you maintain a similar annual premium budget for a decade, you're committing a meaningful amount of capital to something that might never deliver a substantial payout.

And those costs matter enormously when you're trying to compound wealth over many years.

The protection you receive also depends on the options you purchase. Spending 1% or 2% of your portfolio on put premiums doesn't mean you're automatically protected against every decline. The strike price, expiration date, amount of exposure hedged, and performance of your individual investments all matter.

There's another challenge.

You can be right about an eventual market crash and still lose money on your hedge.

Perhaps the market falls six months after your options expire. Perhaps your puts were too far out of the money. Or perhaps the index falls, but not far enough to offset the premiums you've paid.

Predicting that markets will eventually decline is easy. Predicting when, how far, and which protection to own is substantially more difficult.

What History Teaches Us About Risk

One thing I've learned from studying financial history is that there will always be something we cannot predict that ends up having enormous implications for the economy and stock market.

Think about the financial crisis in 2008.

Or the COVID pandemic in 2020, when much of the global economy essentially shut down.

Or the inflationary shock and dramatic rise in interest rates in 2022.

These were very different events, driven by different circumstances, with different implications for businesses and investors.

And I can virtually guarantee that there will be other major disruptions in the future that we aren't even thinking about today.

That's why I think trying to anticipate every potential crisis is ultimately a losing proposition.

Rather than trying to predict the next crisis, I'd rather own businesses that have the resiliency to survive it.

This is a critical part of how I evaluate investments.

When I'm looking at a company, I want to understand how well its business model can hold up if the economy deteriorates.

Does it have a strong balance sheet with limited leverage?

Does it generate substantial free cash flow?

Does it have recurring revenue, or does it sell products and services that customers need regardless of the economic environment?

Does management have a demonstrated ability to navigate uncertainty and allocate capital prudently?

And perhaps most importantly, could the company survive a prolonged period of adversity without needing to raise expensive capital or significantly dilute shareholders?

These questions matter enormously.

For example, there's a meaningful difference between a highly leveraged company selling discretionary products and a financially strong company providing an essential service with recurring customer relationships.

Neither business is immune to a recession, but one may be substantially better positioned to endure difficult circumstances.

Even recurring revenue isn't a guarantee of safety. Customers can cancel, margins can deteriorate, and competitive advantages can disappear.

But I want to stack the odds in my favor.

I don't need my companies to predict the next storm. I need them to be built to withstand it.

And if they're strong enough to survive when weaker competitors struggle, they might even emerge in a better competitive position.

That's a form of portfolio protection I find particularly attractive.

Most Individual Options Traders Struggle to Make Money

There's another reason I'm skeptical about spending too much time trading options.

The historical evidence on individual options-trading performance is not particularly encouraging.

A 2009 study published in the Journal of Banking & Finance, titled

Option Trading and Individual Investor Performance, found that most individual investors in its sample incurred substantial losses on their options investments.

The researchers attributed the disappointing results partly to poor market timing and high trading costs.

More recently, a 2023 study published in The Journal of Finance,

Retail Trading in Options and the Rise of the Big Three Wholesalers, examined U.S. retail options activity.

It estimated approximately $2.1 billion in aggregate losses on the retail trades it studied between November 2019 and June 2021, assuming a ten-day holding period. Trading costs were a significant contributor.

And consider this remarkable statistic from India.

In September 2024, India's securities regulator

reported that 93% of individual equity futures and options traders lost money over the three fiscal years ending in March 2024.

Now, I want to be careful here.

These studies largely concern speculative derivatives trading, and the Indian statistics cover futures as well as options. They don't establish that buying puts to hedge an investment portfolio is a mistake.

Someone purchasing insurance is pursuing a different objective from someone trying to generate trading profits.

But I still think the findings are worth considering.

Options introduce another layer of complexity involving volatility, timing, expiration dates, and trading costs.

And it's worth asking whether that complexity actually improves our investment outcomes.

For my own approach, I'd rather spend more time understanding businesses and less time trying to forecast short-term market movements.

The Hidden Cost of Portfolio Insurance: Lost Compounding

This is where the math gets particularly interesting.

Historically, the S&P 500 has generated a compounded annual total return of approximately 10%, including reinvested dividends, over the period from 1928 through 2025.

You can review the historical data compiled by

NYU Stern professor Aswath Damodaran.

Of course, historical returns don't guarantee future results, and I certainly wouldn't assume every investor will generate 10% annually going forward.

But let's use that figure to illustrate a point.

Suppose you start with $100,000 and have three potential outcomes.

In the first, you compound at 10% annually.

In the second, you compound at 9%, reflecting a hypothetical 1-percentage-point annual drag from hedging.

In the third, you compound at 8%, reflecting a hypothetical 2-percentage-point annual drag.

Here's what happens:

Annualized net return	After 10 years	After 50 years
10%: No hedging drag	$259,374	$11,739,085
9%: 1% annual drag	$236,736	$7,435,752
8%: 2% annual drag	$215,892	$4,690,161

Illustrative nominal values with no additional contributions, withdrawals, or taxes. This assumes a constant reduction in annual returns and no offsetting gains from the hedge.

Look at the difference.

Over ten years, reducing returns from 10% to 8% costs you approximately $43,000 on an initial $100,000 investment.

That's meaningful.

But over fifty years?

The difference is approximately $7 million.

Think about that.

In this hypothetical scenario, a two-percentage-point annual reduction in returns leaves you with approximately 60% less wealth after fifty years.

That's the extraordinary power of compounding, and why seemingly small recurring costs deserve serious consideration.

Now, to be fair, actual hedging results won't necessarily look like this illustration.

A put option could generate a substantial payout during a market crash, offsetting some or even more than the premiums paid. It could also prevent an investor from panic-selling or provide cash to buy stocks at depressed prices.

So a 1% to 2% premium budget does not automatically translate into a permanent 1% to 2% reduction in annual investment returns.

But there is a real hurdle that the strategy has to overcome.

If you're consistently paying for portfolio insurance, those protections need to deliver enough economic value to justify the ongoing cost.

And when your primary objective is maximizing long-term compounding, that's an important consideration.

My First Defense: Evaluate Risk Position by Position

Rather than buying insurance against an entire portfolio, my first line of defense is evaluating each investment individually.

Let's say I own a company because I believe it can grow earnings substantially over the next several years.

A year passes. What has happened?

Has management delivered on its promises?

Has the competitive position strengthened or weakened?

Are margins expanding as expected?

Has the company made a questionable acquisition, taken on too much debt, or allocated capital in a way that concerns me?

These are the questions I care about.

I generally think in terms of a one- to two-year evaluation period when assessing whether management is making progress toward its objectives.

That doesn't mean I automatically sell a stock after two years if the share price hasn't increased.

In fact, if the underlying business is doing well while the stock price has fallen, I might become even more interested.

Conversely, if the investment thesis breaks after six months, I don't need to wait another eighteen months to recognize it.

My willingness to hold an investment should depend on whether the underlying thesis remains attractive, not on how much time has passed or how far the stock price has fallen.

Macroeconomic conditions also enter that analysis.

For instance, what happens to the business if interest rates remain elevated? What if consumers face increasing financial pressure? What if a company's financing becomes more difficult?

Different businesses have different exposures.

A company with a fortress balance sheet and recurring revenue might be able to weather a downturn comfortably. Another company with substantial debt and deteriorating cash flow might face existential risks.

Those two investments shouldn't necessarily be treated the same way.

This is one of the challenges with buying index puts to protect a portfolio of individual stocks.

Your hedge might not match the risks you're actually taking.

I'd rather understand my businesses and adjust my exposures when the facts change.

My Second Defense: Liquidity Is Its Own Form of Protection

The second part of my approach is liquidity management.

I think this is one of the most underrated aspects of successful long-term investing.

When people talk about protecting their portfolios, they often focus on how to avoid losing money during a crash.

But there's another question I find just as important.

Will I have the ability to take advantage of attractive opportunities when markets decline?

Imagine two investors.

The first is fully invested, perhaps even using significant leverage, and has no additional liquidity available.

The second also owns attractive businesses but maintains sufficient liquidity to withstand volatility and potentially purchase additional shares during a downturn.

Now imagine the market falls 30%.

The first investor may be forced to sell investments at precisely the wrong time, particularly if leverage or personal financial obligations create liquidity pressures.

The second investor has flexibility.

They can evaluate which businesses have become more attractively priced and potentially deploy additional capital.

That flexibility can be enormously valuable.

When I believe macroeconomic risks are particularly elevated, I'm more inclined to consider maintaining additional liquidity rather than automatically spending money on portfolio insurance.

That doesn't mean cash is free. There's an opportunity cost to holding it, especially if markets continue moving higher.

And it certainly doesn't mean I can consistently predict when a downturn will occur.

But I appreciate the optionality that liquidity provides.

It allows me to respond to opportunities rather than being forced to react to problems.

What About Investors Like Ray Dalio and Paul Tudor Jones?

There are extraordinarily successful investors who spend substantial time studying macroeconomic conditions, managing risk, and using derivatives.

I have tremendous respect for investors who have demonstrated success with those approaches.

But I think it's important to recognize that different investment strategies require different skills.

A macro trader managing complex exposures may have excellent reasons to use derivatives.

An institution protecting against specific liabilities may rationally pay for insurance.

Someone approaching retirement, who cannot tolerate a major drawdown, may value downside protection much more highly than an investor with a multi-decade time horizon.

And for an individual who would otherwise panic and sell everything during a crash, a thoughtfully designed hedge might help them remain invested.

Those are legitimate considerations.

My objection isn't that portfolio insurance is universally a bad idea.

It's that I don't believe repeatedly buying protection against market declines is necessarily the best use of my capital, attention, or energy.

Especially when my primary objective is identifying businesses capable of compounding their intrinsic value over many years.

How Should You Protect Your Portfolio From a Market Crash?

I would begin with a different question.

Are you trying to protect yourself from temporary stock price volatility, or are you trying to protect yourself from permanent capital impairment?

Those are very different things.

If a great business declines 30% because investors are frightened, but its long-term earnings potential remains unchanged, that could create a tremendous investment opportunity.

If another company declines 30% because its business model has deteriorated or its balance sheet is becoming unsustainable, that could represent a genuine impairment of capital.

Simply buying portfolio insurance doesn't necessarily distinguish between the two.

For me, protecting wealth begins with understanding what I own, paying sensible valuations, being realistic about what could go wrong, and avoiding circumstances that would force me to sell at an unfavorable time.

Sometimes that means reducing a position. Sometimes it means accepting that a business no longer meets my investment criteria. Sometimes it means holding additional cash.

And sometimes it means doing absolutely nothing while the market declines.

There's no perfect solution. Even excellent businesses can experience enormous stock price declines, and holding resilient companies doesn't guarantee that you'll avoid permanent losses.

But my preference is to focus on the decisions I believe I can make intelligently rather than constantly trying to predict the unpredictable.

Final Thoughts: Focus on Building Wealth, Not Just Avoiding Losses

I understand why portfolio insurance is appealing.

Nobody enjoys watching their portfolio fall 20%, 30%, or even 50%.

And the idea of spending a relatively small amount each year to protect against that possibility sounds attractive.

But every strategy comes with trade-offs.

My personal objective isn't to construct a portfolio that never declines.

It's to build a portfolio that can survive difficult economic periods and compound meaningfully over the long term.

That requires managing risk, assessing management teams, understanding valuations, and maintaining financial flexibility.

It requires acknowledging that the next crisis probably won't look like the last one.

And perhaps most importantly, it requires aligning myself with businesses that are capable of enduring uncertainty while continuing to create value.

Because ultimately, I'd rather spend my life trying to identify the next great business than trying to predict the next great crash.

And that's the game I want to play.

If this perspective resonates with you, that's what I focus on at Unrivaled Investing: identifying potentially exceptional businesses, evaluating management and valuations, and sharing how I think about investing through the ups and downs.

This article reflects my personal investment philosophy and is for educational purposes, not individualized financial advice.