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Chapter 1. The No-Frills Investment Stra... > Drawdown: The Measure of Ultimate Ri...

Drawdown: The Measure of Ultimate Risk

Chart 1.3. Closed Drawdowns by Volatility

Drawdown represents the maximum loss taken from a peak in portfolio value to a subsequent low before a new peak in value is achieved. The highest-volatility group, Group 9, incurred losses of as much as 68% during the 1983–2003 period, whereas the lowest-volatility group, Group 1, had a maximum drawdown of just 15%.


Drawdown, the amount by which your portfolio declines from a peak reading to its lowest value before attaining a new peak, is one of the truer measures of the risks you are taking in your investment program.

For example, let us suppose that you had become attracted to those highly volatile mutual funds that often lead the stock market during speculative investment periods, and therefore accumulated a portfolio of aggressive mutual funds that advanced between late 1998 and the spring of 2000 by approximately 120%, bringing an initial investment of $100,000 to $220,000. So far, so good. This portfolio, however, however, declines by 70% during the 2000–2003 bear market to a value of $66,000. Although losses of this magnitude to general mutual fund portfolios previously had not taken place since the 1974 bear market, they have taken place during certain historical periods and must be considered a reflection of the level of risk assumed by aggressive investors. Moreover, this potential risk level might have to be increased if asset values for this portfolio and similar portfolios were to decline to new lows before achieving new peaks, which had not yet taken place during the first months of 2004.

Protracted gains in the stock market tend to lead investors to presume that stock prices will rise forever; buy-and-hold strategies become the strategy of choice. Interest focuses on gain. Potential pain is overlooked. (Conversely, long periods of market decline tend to lead investors to minimize the potential of stock ownership. The emphasis becomes the avoidance of pain; the achievement of gain seems hopeless.)

Drawdowns—and risk potential—decline dramatically as portfolio volatility decreases, although risks to capital are still probably higher than most investors realize, even in lower-volatility areas of the marketplace. For example, maximum drawdowns between 1983 and 2003 were roughly 16% for Group 2, the second-least-volatile group of mutual funds, rising to 20% in Group 3, a group of relatively low volatility. Mutual funds of average volatility, Group 5, showed drawdowns of 35%.

In evaluating mutual funds or a selection of individual stocks or ETFs for your portfolio, you should secure the past history of these components to assess maximum past risk levels. ETFs (exchange traded funds ) are securities, backed by related baskets of stocks, which are created to reflect the price movement of certain stock market indices and/or stock market sectors. For example, there are ETFs called SPYDRSthat reflect the price movement of the Standard & Poor’s 500 Index, rising and falling in tandem with the index. Another ETF, theQQQs, reflects the Nasdaq 100 Index. There are ETFs that reflect a portfolio of high-yielding issues in the Dow Industrial Average, a real estate trust portfolio, and even an ETF that reflects a portfolio of 10-year Treasury bonds. In many ways, ETFs are similar to index- or sector-based mutual funds, have the advantages of unlimited trading at any time of the day, as well as lower internal expenses than mutual funds. There are certain disadvantages, however, mainly associated with bid-ask spreads, which add to transaction costs as well as occasional periods of limited liquidity.

You can fine-tune the total risk of your total portfolio by balancing its components to include lower-risk as well as higher-risk segments. For example, a mutual fund portfolio consisting 50% of intermediate bond funds (past maximum drawdown 10%) and 50% Group 8 mutual funds (past maximum drawdown 50%) would represent a total portfolio with a risk level of approximately 30%, probably as much, if not more, risk than the typical investor should assume.

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