How To Manage Investment Drawdowns By Thinking Differently

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One of my absolute favorite movies of all time is Raiders of the Lost Ark. There’s a famous scene where Indiana Jones is confronted by an intimidating swordsman clad in black, and the crowds part in anticipation of an epic fight.  How does Indy handle such an ominous threat?

I think my favorite part is the look of utter irritation on Indy’s face, as the feared enemy is really more of a waste of time than a true threat to anyone with a clear mind and bit of common sense.  The scene is also a brilliant piece of film making, as the quick and unexpected exchange plays on the expectations of the audience.  A scene like this almost always ends in a drawn-out fight even when it doesn’t have to just because that’s how movies usually work.  But Indy knows better, and the audience is left to laugh and wonder why nobody else has thought of that.

I see a similar dynamic all the time in investing, where the swordsman represents the dreaded market drawdown.  It’s big, it’s mean, and it’s unavoidable.  So what are the options for an investor when confronted with the very real risk of loss?

Here’s a typical sampling of responses — tell me if any of them sound familiar:

 

Toughen up, Buttercup.  Losses are unavoidable, and you need to raise your risk tolerance.

 

Sure major losses have happened in the past and will happen again, but they’re rare and I’m willing to risk failure.

 

Risk is good!  Taking a beating is a normal part of investing!

 

That’s why I actively trade rather than passively invest.  I want to avoid major losses.

 

On the one hand, none of the answers are unreasonable and there’s something to be learned from each of them about how to fight the drawdown swordsman in your path.  However, whether it’s some brand of machismo, denial, financial stockholm syndrome, or over-confidence, the response by many investors reminds me of the expectations of the film audience in that they all assume that a brutal financial fight is inevitable.

Such expectations are not unjustified, as quite a bit of today’s popular investing advice carries substantial risks.  I think that truly understanding the potential downside of our investing options is a critical step in making an intelligent portfolio decision.   Many of the tools on this site are designed to highlight not only the average returns but also the worst outcomes, but after exploring it a bit more I think there’s room for a new tool that helps people see past the positive spin for a portfolio by mapping every single loss in one place.  I call it the Drawdowns calculator.

drawdown-calculator

The Drawdowns calculator maps every single portfolio loss since 1972 from any high point along the way.  Each line represents the effects of the inflation-adjusted compound returns on the portfolio account value, and by studying these lines one can see not only how deep the losses cut over time but also how long they took to recover.

Astute observers may note that some of the lines dive from positive to negative in later years on the chart.  This is because the calculator does not simply declare the portfolio recovered when it temporarily turns positive only to return below the baseline later.  A loss briefly interrupted by a head fake is still a loss, and a drawdown is only declared resolved when the portfolio permanently recovers above its original value.  Also, one should note that the deepest drawdown number is based solely on year-end returns.  It’s absolutely possible that a portfolio experienced something even worse than that in the middle of a year.

As you can see from the chart, the downside risk for putting all of your money in the stock market is substantial.  A 51% deepest drawdown, regular losses of 30%, and a longest drawdown lasting 13 years make for a particularly scary market swordsman.  If one accepts that such risk is the price to pay for investing, then the advice to toughen up and learn to brawl your way through it makes sense.

However, allow me to don my Indiana Jones hat and pull out my asset allocation pistol.

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Interesting!  If deep drawdowns bother you more than long ones, the Desert Portfolio is a great choice.  If long drawdowns bother you more than deep ones, the Merriman Ultimate might deserve a look.  And if you prefer to limit losses in general, the Golden Butterfly has been far more stable over the years than the stock market.  Remember, the charts do not show just a few selected losses — they show all of them.

The dreaded market swordsman in black doesn’t look so tough anymore.

Each portfolio has a different drawdown profile, and you can explore the Portfolio pages to look for many more options.  You can also play with the new Drawdowns calculator to try out your own ideas.  Of course the past can’t predict the future, and there’s nothing to say that this year won’t mark the start of a new worst-case scenario.  But studying the past for evidence of consistency can absolutely help you size up the known drawdown opponent you’re facing.

And by the way, be sure not to fall into the trap of believing that lower risk must also mean proportionally lower returns — despite what you’ve heard, asset allocation doesn’t always work that way.  Explore the other charts and calculators and you’ll see that for yourself.  The Portfolio Finder is especially good at finding low-loss / high-return portfolios, and with new information in hand I’ll be adding Deepest Drawdown data shortly.

My hope is that this information will be informative not only for passive investors who are trying to quantify their own risk tolerance but also for active ones. Whether your instinct is to power through risky investments or actively try to dodge the worst of their attacks with P/E ratios and moving averages, I think that by objectively studying the worst-case results of a passive approach one can acquire some much needed perspective.  Maybe all of that pain and effort truly is necessary to meet your personal goals, but maybe it’s not. Perhaps there’s a much easier way forward you simply haven’t considered.

Indiana Jones chose brains over brawn and saved his energy for more productive activities.  Try the new Drawdowns calculator and decide for yourself — What type of investor are you?