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.