April 19, 2024


Entertain Reaching Stars

Investing: The Best Way to Win Is By Not Losing A Lot – The Concept of Drawdown

3 min read

“Our fund is in the top of its Lipper Category.” “Our fund has a Five Star Rating from Morningstar.” “Our fund has gains of X% over the past year,(or 3 years or 5 years)” How many times have your heard such claims/statements from investment companies, mutual funds, or insurance companies regarding their funds or sub-accounts? My guess is, a lot. But did you know that the market, as represented by the S&P 500 has spent a whopping 82.95% of the time between 1927 and 2012 going into, or climbing out of a significant market decline?

I’d like to introduce to you the concept of “drawdown.”. Drawdown can be summarized as the gap between the absolute top or peak in performance of an investment(or market,or sector) and its bottom, or trough. During the recent market downturn from 2007-2009, a very popular large cap mutual fund had a drawdown of -52% from its peak in May 2007 to its absolute bottom at the end of February 2009.

Now to extend the concept of drawdown even further, we are going to consider the period of time that it takes to get out of the bottom to be included in the period of drawdown. It makes sense, don’t you think? Until you get back to where you were you can’t really say you are back on the road to your retirement goals that you were on before the decline, right? So the fund manager has to reclaim ground that he lost before getting any real gains. Unfortunately, this is not something that is clearly revealed by investment companies or by “star ratings,” nor is it required to be.

Now to explain the final part of the concept of drawdown, how much is needed to recover to your prior high ground, is not cut and dry. In fact, the amount increases proportionally with the loss. That is, the more you lose, the more you have to gain in order to just get back to where you were. For example, if you lose 10%, say, you need to gain 11% to get back to where you were, and then be in the positive from there. Moving up, a 20% loss would require a 25% gain to get back to equilibrium. Still not bad, but not moving in a good direction. A 20% loss is kind of the “line in the sand” as far as reasonable recoveries, Going to a 30% loss would require a teeth clenching 43% gain, over 5 times the oft repeated 8% average gain of large cap stocks. Finally, our large cap mutual manager in the second paragraph, with his/her 52% loss would require just over 100% to get back on the positive path. Therefore, going back to the examples at the beginning of this article, a particular investment or mutual fund manager might very well have earned X%, AND have a Top of Category Lipper Rating, AND/OR a 4 or 5 Star Morningstar rating, BUT it STILL might not be back to “ground zero.” Again, you most likely aren’t going to be told this.

What is the takeaway (no it’s not to depress you)? It’s to get you to take an active role in the management of your hard earned money. Ask questions. What makes the manager buy? Why would the manager sell? What does he/she do when his/her sector of the market is in hard times? When does he/she buy back in at the bottom of a market if they had the foresight to get out in time? (Knowing when to buy and sell are both important for success) If you are paying extra for active management, these are things you should know.

While most amusement park roller coasters go up a hill to get back to the drop off/pickup area, there is no guarantee your “retirement roller coaster” will. You, and/or those who handle your money need to have a strategy with clearly defined entry/exit points and parameters during the ride.

Good luck and have a prosperous day.

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