Drawdown Risk
Investment risk is not always easy to quantify. It is often complex, requires advanced knowledge of statistics, and is best left to experts who enjoy quantifying markets as their career choice. In my opinion, few advisors are adequately prepared to quantify traditional investment risk. But, calculating Drawdown risk is easy. It's simply expressed as the percentage difference in an investment's peak to its trough.
Many investors are taking far too much risk, especially if they're using their investments to help pay their bills. An account that has decreased in value requires a higher rate of return to recover. For example:
Start with $100
Suffer 25% loss
Now valued at $75
Earn 25%
Now valued at $93.75
Introduction
Many investors take more risk than they should while attempting to grow their nest egg, and far too much risk if they're using their investments to help pay their bills.
Why would someone invest in something with a higher risk if their potential return is similar to that of lower-risk? The logical answer is that they wouldn’t – but yet they do!
Doesn't it make sense to evaluate the risk of loss as strongly as the potential return? To do so, it helps to use a measurement known as the drawdown risk.
Hopefully this discussion will help the average investor with more informed choices and make some money.
The bottom part of the chart (left) (from Zephyr Associates, Inc.) shows Drawdown. The top chart indicates two huge market corrections and can lead to the incorrect assumption that the rest of the time the market had a pretty smooth and steady increase (at least from 1978 to 1999). However, the lower drawdown chart shows that it wasn’t such a smooth increase.
Soon after 1978, negative returns of 5, 10, and 18% are shown. Notice a 30% drawdown before 1989 that barely is visible in the cumulative performance chart. Are you starting to see the importance that should be placed on the drawdown statistic?
What do you think the average investor did during some or most of the drawdown periods? Did investors ride them out or panic sell? As you can read in DALBAR’s 20th Annual Quantitative Analysis of Investor Behavior, most investors panic and sell at the most inopportune times. If retirement is in the near future, the drawdown effects can be devastating.
Let me ask you this: Which one of the following is the best investment?
Investment 1 with a net return of 9% Drawdown risk of 4%
Investment 2 with a net return of 9% Drawdown risk of 10%
Investment 3 with a net return of 9% Drawdown risk of 20%
Obviously, Investment 1 is the choice. Does it matter what asset class the investment is? No, if the drawdown risk is low it doesn’t matter.
The following chart of SPY (SPDR S&P 500 ETF) between 2005 to the end of 2012 illustrates two major drawdowns - one of 55.2% and the other 18.6% in 2011.
During this time period, the S&P 500 generated an average compounded rate of return of 4.9%. To generate that return, the investor risked losses of 55.2% and 18.6%. Does that sound like a good bet to you?
Look at the statements below. To recover from a 50% loss, a gain of 100% is required! No wonder it takes so long for investors to recover. Isn’t it smarter to use a strategy of not losing rather than a “buy and hold” mentality?
A 20% loss requires a 25% gain to recover the following year
A 30% loss requires a 42.9% gain to recover the following year
A 40% loss requires a 66.7% gain to recover the following year
A 50% loss requires a 100% gain to recover the following year
Tactical Managed Accounts
Tactical money management (TMM) is simply another term used for active management. A tactically managed account is one in which a manager can sell a position to be out of risk, or enter the market when they feel market risk is low.
Many investors are not aware that most mutual funds are forced to be invested, often at 80% at all times by their own prospectus. That is why mutual funds can experience a severe loss during a drawdown.
In my opinion, the goals of a money manager should be to limit drawdown and obtain annualized returns of 6-7% above inflation. A TMM strategy requires the use of a professional money management team that actively trades the portfolio to meet investment objectives. Thus, no need exists for the average investor to actively trade such funds.
TMM accounts can be utilized in most any type of retirement plan. I have used TMM accounts as part of 401(k) plans as well as Individual Retirement Accounts. They can even be added to existing plans if the adviser and third party administrator are willing. For more information, click on the following button, tell me how to reach you, and we'll see if a TMM makes sense for you.
Conclusion
It is easy to invest in a market while on a multi-year run in the positive direction. But, it becomes more challenging to invest in today’s volatile environment. Severe drawdowns in the market can be avoided by limiting risk. A tactical money manager is best suited to avoid severe drawdowns. A tactically managed account should be incorporated into investors’ portfolios.
The percentage of a portfolio designated to tactical management is a decision that an investor should probably seek the opinion of a professional to help make.
A buy and hold strategy may sound good in theory; but as the DABLAR Report indicates, the average investor is incapable of buying and holding. Instead they panic sell near the bottom of a downturn which costs them significant returns in the short and long term – even when they employ a local money manager.
No offense to the local stockbroker; but if he/she were that good, he/she would be running hedge funds or true tactically managed funds. I prefer to leave the buy-and-sell decisions to true tactical money managers and, preferably, one who has an actual track record of success rather than just back-dated results!
Yes, I want to learn more about setting up a Tactically Manage Account!