Both outperform in Up and Down markets. I would think CPPI does better since buys more (reduces more) in proportion to cushion. But text states both outperform.
Both also have floor value where risk tol drops to zero when the cushion is zero.
Any other major differneces?
well they are derived from the same formula, so I would tell you to test it :
in stock = M \* ( portfolio - Floor $)
where for a buy and hold M = 1 let’s try this:
portfolio = 1 000 000, floor = 500 000 m = 1
so you have 1* ( 1 000 000 - 500 000) = 500 000 allocated to stocks. this means that you have 50% stock.
portfolio rise, it goes up to 1 200 000, then you have 1*(1200000-500000) = 700 000$ allocated to stocks or 58.3%.
Let’s start at the same mix with a M = 1.2 ( now this is a CPPI since M >1 )
to start with a 50% mix, you need a floor of 583 333$ :
1.2 ( 1 000 000 - 583 333 ) = 500 000$ allocated to stock or 50%.
now let’s assume that you are now at 1200 000 your allocation will be
1.2 ( 1200000-583333) = 740 000$ or 61.6% of your portfolio invested in stock, so as you can see your allocation to stock grow faster than buy and hold and this explain why it will outperform in a raising market ( since you have more money added to equities )
if you retest for 800 000$ instead of 1 200 000$ you see that the allocation to equities will be 32.5% for CPPI and 37.5% for B&H which means that CPPI will still outperform in a down trending market since it sell equities faster.
so the very important information is that CPPI has a convex relation between portfolio return and stock returns but B&H has linear relationship
SO CPPI is always better than Buy and Hold, why would someone pick buy and hold? Is that where risk tolerance plays a role?
Depends on what you are looking for, I think.
If you are looking for best strategy, then most likely CPPI.
If you are looking forf suitable strategy to someone who looking for a floor value and a more risk when upward trending, then both works.
In fact, if in above case and inadittion, the person is looking for lower admin cost, then only choice will be B&H.
Hope this helps.
I don’t quite know what you mean when you say that they both outperform in up and down markets: outperform what?
In a trending market (up or down), CPPI outperforms B&H, and B&H outperforms constant-mix. Is this what you mean?
In a volatile, nontrending market, constant-mix outperforms B&H, and B&H outperforms CPPI.
S2000 said it right, volatility is key here. Even if the market is trending but is highly volatile, B&H may outperform CPPI since CPPI tends to Buy high and sell low.
Easy answer is the level of active investment and transaction costs