Drawdowns Matter!

One of my biggest knocks on the Securities and Exchange Commission (SEC), which was created to protect investors, is that mutual funds are not required to include Drawdown statistics in fund literature and prospectuses.

What’s a Drawdown? It is the peak-to-trough decline in value of an investment during a Correction or Bear Market.

The SEC mandates that funds provide 1, 3, 5, and 10 year returns in their literature. There is no requirement that drawdowns be reported. Of course, that is pretty much the norm in the financial industry because given enough time, market returns are always positive but drawdowns are always negative. Who in the financial services industry wants to talk about negatives?

Thousands of funds were down 30%-60% during the Late Great Bear. Those same funds are now advertising positive 1/3/5/10 year returns. To find the drawdown, you’ll have to locate a long term chart and manually calculate the drawdown.

My first question when considering an investment is always “what is the drawdown?”. In other words, I insist on knowing what I’m going to risk before I have any interest in hearing about potential rewards. My website lists five reasons to be concerned about drawdowns but I’m going to discuss the two most important.

Drawdowns must be fully recovered before the portfolio can return to growth. Portfolios are binary: on any given day, they are either growing or shrinking. The more a portfolio shrinks, the more it must recover before it can return to growth. If the holes are kept shallow, portfolios spend more time growing and less time recovering. The secret to growing a portfolio (and sleeping well at night) during a full market cycle is finding the lowest drawdowns, not the highest returns.

Investors approaching, or in, retirement may not have the luxury of the time required to recover losses. Bear Markets consume our most precious asset - time. The most recent Bear Market recovered relatively quickly: SPY, the S&P 500 fund, peaked in Oct 2007, hit its low in Feb 2009, and returned to its previous high in April of 2013, a period of 5-½ years following a 51% drawdown. However, the April 2013 high barely exceeded the August 2000 high, a much longer period of 12-⅔ years.

   1972 - 1980 (46%) lasted 7-½ years
   1937 - 1950 (57%) lasted 13-¼ years
   1929 - 1954 (86%) lasted 25 years.

The current extremes in historical market valuations suggest that the next Bear Market will likely require 10-15 years to recover. And the effect of drawdowns will be exacerbated by any withdrawals taken during the period.

Bear Markets share one characteristic across history … they decline quickly and recover slowly. The trick is to minimize the drawdown during the sharp decline. This puts you in a position to ride the recovery for fresh gains. That’s our secret sauce. Our Tactical Asset Allocation strategies are designed to reduce lower risk during declines and improve returns during the recovery.

To summarize, minimize your drawdowns and the returns will take care of themselves. The next time you are tempted by prospective returns, ask to see the Bear Market drawdowns. If there is no Bear Market history, or the drawdowns exceed your comfort level, look elsewhere. You don’t have to look hard on this website, you’ll find historical drawdowns shown right next to our historical returns.

 

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