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Author: Rayvt Big gold star, 5000 posts Top Favorite Fools Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75825  
Subject: Re: Distributions of S&P500 returns Date: 4/1/2013 12:03 AM
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...That's not the case, though. The majority of the major annual rallies occur after significant down trends... and this has a major reduction effect on the benefits of capturing "all the rally upside" above caps.
Absolutely. You have grasped a point which eludes many many authors and writers. See: http://ssrn.com/abstract=1908469

Losses tend to cluster, and gains also tend to cluster. So the simple statistics that people toss about don't tell the whole story.

This is why a floor/cap hedge outperforms in volatile markets, and particularly excels when there are significant bearish periods. When there is a strong certainty of straight rally years greater than a particular cap, then going naked is better.
Yup.
The challenge is designing a strategy that avoids the bad outcomes but keeps the good outcomes. This is extremely difficult.

The market risk is there. It is what it is. It cannot be eliminated, only shifted around. If A wants to get rid of risk he can only do so by sloughing it off to B. B will only take on this risk if he gets paid for doing so. Insurance companies are pretty good at pricing risk and rarely undercharge for it. They change the risk profile that A is exposed to, and they charge A for doing so.

And this whole discussion is more appropriate for the M.I. board than this board. ;-)

What is the rough probability of consecutive S&P rally years greater than 12%, without intermediary years below zero to wipe out the above-cap gains?
That's a good question.

The table I posted did not address sequence of returns, nor was it meant to.
The table merely answers the question, "So, how often did the historical returns fall into these various buckets, anyway? Just how many times were capped off?"
And secondarily, "What is the density of the returns in the buckets -- how much did each bucket contribute to the overall return?"

I put this in a different thread because it's really a separate issue from the IUL srategy, where the sequence of returns *does* matter.
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