3 Ways to Manage Drawdown Risk
Markets are in a strange place right now. Are we about to have another crash like we had in March? Or will central banks keep pumping liquidity into the markets to keep the party going? Whatever happens, investors need a plan to manage drawdown risk in these uncertain times.
What is drawdown?
Drawdown is the maximum decline of an investment from its highest point (peak) to the next lowest point (trough). Using the Corona dump of 2020 as an example, we can see this for the S&P 500 below:
By August this year the S&P was back to new all time highs. While this worked out well for investors who bought the dip, drawdowns often last much longer. Below we can see how silver shed roughly 76% over a much longer period in recent history:
Why managing drawdown is essential
Investment risk is often measured by the standard deviation of returns—how much returns vary over time. This provides useful insight into the volatility of an investment but it does not factor in worst case scenarios. Drawdown does.
Bitcoin, for example, returned a huge amount over the last decade. The standard deviation of these returns each year have been very high. But this metric does not distinguish between good (upside) volatility and bad (downside) volatility.
To get a true sense of the risk Bitcoin holders had to endure on the road to riches, we need to look at historical Bitcoin drawdowns.
The table above shows us why investors should take drawdown very seriously. A 50% decline in the value of an investment needs a 100% increase to get back to break-even.
This problem becomes exponentially worse as losses grow larger. Take November 2013 for example, where bitcoin crashed 87%. In this case, an investor who bought one bitcoin at the $1,172 peak and never sold would have seen his investment fall to $152. From that price point, he would have needed a 669% return to recover his initial investment. This would have taken 410 days.
Using this example, we can see two reasons why drawdown risk matters:
- Larger drawdowns always need higher percentage gains to recover.
- Larger drawdowns often take longer times to recover.
Here are three ways manage drawdown risk…
1. Diversify among different asset classes
Diversification is one of the best ways to prevent losses. This is because not all investments drop at the same time or by the same amounts. In March this year when stock markets were collapsing, many bond funds made money.
The M&G Global Macro Bond Fund, for example, rallied roughly 8% in the time it took the S&P 500 to drop 35% in February and March of 2020.
Gold also fell much less than the general stock market at this time.
2. Invest small sums often rather than a large amount all at once
Investing a large amount of money all at once exposes investors to more drawdown risk. One way to offset this risk could be through dollar cost averaging or value averaging.
These strategies help us build up positions over time without the risk of going all in at the top of the market. Not only that, but they also mean we can buy (some) of the dip if things get really cheap.
3. Don’t over-leverage
Traders who use too much leverage suffer much bigger drawdowns. A 10% loss on an over-leveraged trade can wipe out your account. I wrote another post earlier this month on trade position sizing which explains this in more detail.
Disclaimer: nothing in this article is investment advice. I currently hold the M&G Global Macro Bond Fund and gold.