Investing: the best way to win is not to lose much – the concept of Drawdown

“Our fund is at the top of its Lipper category.” “Our fund has a Five Star Rating from Morningstar.” “Our fund has gained X% over the last year (or 3 years or 5 years)” How many times have you heard such claims/statements from investment companies, mutual funds or insurance companies regarding their funds or sub-accounts? My guess is, a lot. But did you know that the market, as represented by the S&P 500, spent a whopping 82.95% of the time between 1927 and 2012 entering or climbing a significant market downturn?

I would like to introduce to you the concept of “drawdown”. Drawdown can be summarized as the gap between the absolute top or peak performance of an investment (or market, or industry) and its bottom or bottom. During the recent market downturn of 2007-2009, a very popular large-cap mutual fund had a drawdown of -52% from its peak in May 2007 to its all-time low in late February 2009.

To extend the concept of drawdown even further, let’s look at the time it takes to get out of the bottom to be included in the drawdown period. It makes sense, don’t you think? Until you get back to where you were, you can’t really say you’re back on track for your retirement goals you had before the downturn, can you? So the fund manager has to regain ground it has lost before it can make any real profit. Unfortunately, this is not clearly disclosed by investment companies or by “star ratings”, nor should it be.

Now to explain the last part of the concept of drawdown, how much it takes to recover to your previous high ground is not cut and dry. In fact, the amount increases proportionally with the loss. That is, the more you lose, the more you have to gain just to get back to where you were. For example, if you lose 10%, you need to gain 11% to get back to where you were, and be positive from there. Going up, a 20% loss would require a 25% gain to rebalance. Still not bad, but it’s not going in the right direction. A 20% loss is sort of a “line in the sand” as far as reasonable recovery goes. Going to a 30% loss would require a teeth-gritting gain of 43%, more than 5 times the oft-repeated 8% average gain of large-cap stocks. Finally, our large-cap investment manager in the second paragraph, with his/her loss of 52%, would need a little over 100% to get back on the positive path. Therefore, going back to the examples at the beginning of this article, a particular investment or mutual fund manager could very well have earned X%, AND have a Top of Category Lipper Rating, AND/OR a 4 or 5 Star Morningstar rating , BUT it may not be back to “ground zero” YET. Again, you will most likely not be told this.

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What’s the takeaway (no, it’s not to depress you)? It is to let you take an active role in managing your hard earned money. Asking questions. What makes the manager buy? Why would the manager sell? What does he/she do when his/her market sector is struggling? When does he/she buy back at the bottom of a market if he/she had the foresight to get out in time? (Knowing when to buy and sell are both important to success) If you’re paying extra for active management, these are things you need to know.

While most amusement park roller coasters go up a hill to return to the drop off/pick up area, there is no guarantee that your “retirement roller coaster” will do the same. You, and/or those handling your money, should have a strategy with clearly defined entry/exit points and parameters along the way.

Good luck and have a prosperous day.