Maximum Drawdown – Portfolio Management is as Much About Controlling Losses As It Is Making Money

by | Portfolio Management

Maximum Drawdown

Maximum Drawdown

What is a Drawdown?

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.

It should be the goal of every investor to use portfolio asset allocation to combine non-correlated assets in such a manner as to minimize risk and optimize potential gains. Portfolio drawdown is the most practical and ultimately the best measurement of portfolio risk.

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.

When investors make asset allocation investment decisions they should have their maximum drawdown at the top of their list of considerations. The reason for this is that large drawdowns destroy the capital you need to invest when bargains are available.

This simple chart is one of my favorites because its message is profound. Notice the amount it takes to make your money back after portfolio drawdowns grows exponentially. If you lose 10% of your portfolio, it only takes an 11% gain to get back to break even. If you lose 50% of your portfolio, it takes a 100% gain to break even. If you lose 75% of your portfolio it takes a 300% gain to get your money back.

If You Lose:

Gain Required to Break Even:

5%

5

10%

11%

15%

18%

20%

25%

25%

33%

30%

43%

35%

54%

40%

67%

45%

82%

50%

100%

75%

300%

90%

900%

You must preserve your principal in bear markets to be a successful investor! This is where most investors mess up: They pay too little attention to investment risk. Over the years I’ve known people who were gleeful that they were achieving higher rates of return than I; only to have their portfolio destroyed in the next bear market.

Anyone can make money in rising markets. The true test of a good portfolio manager is avoiding large drawdowns in bear markets.

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 control your risk.

Related Reading:  Probable Maximum Loss – How to Control Investment Portfolio Losses

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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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