Drawdowns and the Concept of Maximum Drawdown

by | Portfolio Management

Drawdown

Large drawdowns are a cause of tragic investment failure. Drawdowns destroy investment capital and more often than not, shatter an investor’s confidence. Sometimes it even causes investors to lose their motivation to continue investing.

Losing your principal is the biggest risk in investing. Most investors don’t realize how devastating large portfolio drawdowns are to their long term returns. I will demonstrate the importance of avoiding these drawdowns.

What is a Drawdown?

The simplest definition is “the act, process, or result of depleting” (TheFreeDictionary).

A drawdown is a measurement of decline from an assets peak value to its lowest point over a period of time. The drawdown is usually expressed as a percentage from top to bottom. It can be measured on any asset including individual stocks or sectors. However, it is most valuable as a measurement of portfolio risk.

Investment Failure Caused By Large Drawdowns

Drawdowns destroy your future. They rob you of the investment capital you once had to grow your portfolio. Keeping drawdowns as small as possible is more important than high returns. This is why:

Drawdowns - Breakeven

Notice how the required gain to break even grows exponentially the greater the drawdown. This is because you are losing the investment capital that could be making you money when your investments are rising.

It takes an 11% gain to recover a 10% loss. Not a problem.
It takes a 25% gain to recover a 20% loss. Harder.
It takes a 43% gain to recover a 30% loss. Problem.
It takes a 67% gain to recover a 40% loss. Big problem.
It takes a 100% gain to recover a 50% loss. Devastating.
It takes a 300% gain to recover a 75% loss. Catastrophic.

Five years of 15% annual gains followed by a 50% loss leaves you back where you started 6 years earlier. Nine years of 10% annual gains followed by a 57% loss (2007-09 bear market) puts you at break even for the entire decade.

Maximum Drawdown

Bear markets are a part of investing. Over the last 200 years we have experienced a financial crises every 4-5 years on average. Periodically we experience bear markets that last as long as 20 years.

You must preserve your capital in bear markets to be a successful investor! This is where many investors experience failure. Over the years I’ve known people who were exuberant that they were achieving higher rates of return; only to have their portfolio destroyed in the next bear market.

When investors make asset allocation decisions they should have their maximum drawdown at the top of their list of considerations. At the forefront of those decisions should be the fact that large drawdowns destroy the capital you need to invest for your future.

Be Fearful When Others Are Greedy

In general, investors are too greedy when prices are high. Our emotions cause us to want to be part of the crowd. We compare our returns to the indices. We listen to our friends and colleagues who only boast when they are doing well.

When valuations are high, the probability of large drawdowns is high, yet we become careless and fixate on high returns. Instead, as valuations become excessive, we should be increasingly concerned about preserving capital for the time when valuations offer probabilities for success that are heavily in our favor.

It should be the goal of every investor to use portfolio asset allocation to combine non-correlated assets in such a manner as to optimize potential gains, but within their tolerance for maximum drawdown. A part of asset allocation is determining how much cash, or other non-correlated assets, you want to hold in your portfolio.

Modern Portfolio Theory uses standard deviation as the measurement of risk. I recommend people understand the concept of standard deviation because probabilities play a major role in determining your risk. However, it is not the true risk that you should be focused on. Your ultimate risk is a large portfolio drawdown and the reason you should consider your probable maximum drawdown.

It’s easy to make money in rising markets. The true test of a good portfolio manager is avoiding large drawdowns in bear markets. While nobody is able to consistently time the market, we know every bear market in history has begun when valuations were high. This makes valuation timing a key concept in protecting your investment capital.

Portfolio management is as much about controlling losses as it is making money. To improve your long term returns start using the financial concept of maximum drawdown to manage your risk.

I use a formula or calculation to guide my long term asset allocation target. You might be interested in reading this post: Probable Maximum Loss.

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Three Asset Allocation Portfolios designed to save you time! The highest priority of each portfolio is minimizing portfolio drawdowns. We focus on ideas and concepts inspired by Benjamin Graham (The Intelligent Investor) and Howard Marks (The Most Important Thing).  Focus is on margin of safety, risk management, proper asset allocation, and avoiding behavioral errors!

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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