Portfolio insurance’s real risk was internal self-impact, not external shocks.

Evidence

It was accepted by all involved that, at least in the absence of jump protection, portfolio insurance would fail if a dreadful external event caused the market to fall discontinuously if, as Leland warned pension fund officials, “one morning, we learn that the Russians have invaded Iran and all the Mideast oil supplies are being cut off” (Leland interview). What gradually became more salient, however, was a risk “internal” to the markets. In a BlackScholes world, adjustment of the replicating portfolio does not affect the price of the underlying stock, the market for which was implicitly taken to be large, liquid, and efficient: the Black-Scholes option-pricing equation “assumes that you can’t affect either stock or options prices, by placing orders,” wrote Fischer Black (1990, p. 13). Would that still be the case as portfolio insurance became big business? — Donald MacKenzie, An Engine, Not a Camera, 807

Categorization

• DEEPTHINKING: The reversal here — the danger to a strategy premised on price-taking turns out to be the strategy’s own scale altering prices — is the crux of the performativity thesis: a model cannot assume away its own market impact once it is widely adopted. This is the seed of the 1987 crash story.
• XREF: Directly anticipates the reflexivity problem later formalized by Soros and by MacKenzie’s own performativity framework, and echoes the law-merchant literature where institutions emerge to close gaps theory ignores. — connects to: The log-normal assumption may have been self-undermining through portfolio insurance. — Donald MacKenzie & Yuval Millo, Constructing a Market, Performing Theory, 191; Portfolio insurance designed to limit losses can amplify market volatility. — Shapiro, Susan P., The Social Control of Impersonal Trust, 144; Widely adopted portfolio insurance would amplify market price movements — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 809 (+1 more)
• SEED: This reversal — a strategy premised on not affecting prices begins to affect them simply by growing — is a strong essay angle: ‘the self-undermining assumption,’ or how a theory’s success can destroy its own validity conditions.

Broader Connections

• Portfolio insurance designed to limit losses can amplify market volatility. #qualifies (0.90) — Shapiro, Susan P., The Social Control of Impersonal Trust, 144
• Widely adopted portfolio insurance would amplify market price movements #complicates (0.85) — Donald MacKenzie, An Engine, Not a Camera, 809
• Portfolio insurers built practical safeguards for events their models excluded. #expands (0.82) — Donald MacKenzie, An Engine, Not a Camera, 806