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.
This article was republished with permission from Arbor Investment Planner.