The Drawdowns chart maps every single portfolio loss from any high point along the way. Use this to study just how low a certain asset allocation has fallen, how long it has taken to recover, and generally how prepared you are both emotionally and financially to handle the downside risks with your own life savings._
How To Interpret The Chart
In contrast to most portfolio explanations that generally seek to portray an investing idea in the most flattering possible light, the Drawdowns chart is designed to highlight the worst timeframes for any given portfolio. Each line represents the inflation-adjusted compound returns of a single start year, with every possible start year overlayed on the same chart.
Note that the color of the lines is sorted by start year. Darker lines are from older start years while lighter lines are from more recent start years. Depending on the portfolio, you may also see gray lines. These indicate start years with incomplete data where the returns are only estimated based on the best numbers I have available.
The deepest drawdown is the largest compound loss for the portfolio since 1970 regardless of start date. Think of it as being the unluckiest investor in history who invested their money at the worst possible time. While it’s true that you may not be so unlucky, it’s important to realize that you are not special and this is the experience that real people before you have dealt with. If the deepest drawdown for a portfolio is larger than your own risk tolerance, then perhaps you should think twice about investing in this portfolio. But if it is something you can deal with, then you can sleep well knowing that you chose something you can be confident in even when times are tough.
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.
The longest drawdown is the longest time it took for a particular portfolio loss to regain its initial value. Note that the numbers are adjusted for inflation, so while the nominal account value may have recovered sooner than reported, the charts track your actual purchasing power. The value of everyday goods can change quite a bit over a decade or more, so inflation-adjusted returns are critical for evaluating long-term portfolio losses.
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.
The Ulcer Index was first described in The Investor’s Guide to Fidelity Funds: Winning Strategies for Mutual Fund Investors, by Peter Martin and Byron McCann. The basic idea is to find a single number that can serve as a reference point for historical portfolio pain that 1) is far more informative than the standard deviation number most often quoted as a proxy for risk; and 2) accounts for both the depth and length of a drawdown. After all, a shallow drawdown that persists for a long time is not necessarily any less painful than a sharp one that recovers relatively quickly. You can read more about how it works here, but long story short the Ulcer Index is a pretty decent measure of the total white area above each of those red lines.
Original Overview : How To Manage Investment Drawdowns By Thinking Differently
How the Ulcer Index Works : The Ulcer Index Is A Helpful Way To Quantify Portfolio Pain