Different people obviously have different goals. Some want to maximize returns while others are willing to sacrifice some return for lower volitility. Obviously huge returns with no drawdown would be the best outcome. What are people’s feelings on realistic compounded annual returns and drawdowns. Do you aim for 50% plus annual returns ans are willing to suffer the occasional 25% DD, or do you prefer maybe 15-20% per year with no more than a 15% drawdown? I am aiming for 20-25% after taxes on a long/short portfolio with no more than a 15% DD. How about you? Might be interesting to see what different people’s ideas and risk profiles are like.
Frankly I think this is totally unrealistic…
The only way to reduce the drawdown risk is to reduce the exposure to the market, i.e. keep more money in cash.
To be honest I never understand why people are worried about drawdown. If the drawdown is excessive ( > 75%) then this can cause a problem because it makes a recovery harder, and may well be the case that you are overbetting (more than the Kelly criterion). As a rule, I would like to aim never to lose more than 50%.
Given that the market (as a whole) had several drawdowns during the 20th century in excess of 50%, I think that is the minimum you should expect. If you cannot tolerate that, then keep half your money in cash for a 25% drawdown, or 2/3rds in cash for a 15% drawdown etc.
Obviously this gives a penalty of reducing long term returns, and i honestly don’t understand why people (who are not near retirement) consider this a worthwhile payoff.
Surely if your time horizon is sufficiently long, you should be attempting to maximise the rate of return, subject to no “overbetting”, because over the long term the exponential growth of every extra percentage point you can eek out gives much greater long term returns.
However, believing any strategy will only give a limited drawdown is, in my opinion, highly dangerous. Long term capital management gave very limited drawdowns until one day, BOOM. I am not convinced long/short equity funds will experience drawdowns less than market funds - in 1998-2000 many experienced severe drawdowns by being long “traditional value” and short internet stocks. So I would go back to my original statement, if you think you can achieve 15-20% per annum with only a 15% DD risk, you are severely fooling yourself, and that is bad because you may well react very badly when the enivitable finally occurs.
Oliver,
Hmmmm. While I don’t quite share your view of expectations, I do think a person needs to assume that an actual drawdown of up to 2x the model’s drawdown can occur.
But the reason we are all here is to find the best balance of risk:reward. We’re not just investing in buy and hold index funds here.
I’ve been hearing/reading some stuff recently about trading in different time frames, even with the same stocks. e.g. Holding a core portfolio of stocks for the long term, but also trading the same stocks short-term. This is intriguing, and is something I am going to be looking into.
But back to Charles’ initial question: I find that I start to get nervous if my overall drawdown exceeds 15%. But I’m in it for the big bucks, and I know that 25-30% drawdowns do occur. I’m OK with that.
Brian
I think this is a good point, though I would say that “2x” may or may not be true, it may be greater or less than that.
Just as long as you realise your maximum simulated drawdown has no bearing on your real maximum drawdown risk.
A couple of problems:
-Max drawdown is just one data point, statistically insignificant, do not read too much into it.
-Some sort of exogenous shock, not necessarily from where you think it might come from, Terrorism arguably caused a minor shock in the indicies, but the crash of 1987 was way outside of anyone’s models.
-You have almost certainly designed a system to reduce max drawdown, and eliminated trading systems that show a large max drawdown. This is a form of survivorship bias, and indeed curve fitting.
As a result, I would almost suggest that the numerical value of the max drawdown has no predictive power in the max drawdown in real time.
However, what I believe can be said, is that strategies with a relatively lower drawdown than others (over the same time period) are likely to have lower drawdowns in the future.
As a result of the above limitations, I would suggest you go to the most conservative estimates about possible future drawdowns, in which case, any equity investment a 50% drawdown seems quite possible.
However, the fact that Warren Buffett has experienced such modest drawdowns (though this is only based on annual data) does suggest better strategies do indeed have reduced drawdowns. However, this cannot be relied upon.
Why do you get nervous? I believe that drawdowns do reduce your downside risk. If the stocks have become cheaper then they have less far to fall. Provided you are following a sound strategy (not averaging down into Enron)
Ultimately I think every investor should decide what drawdown they are comfortable with. If the market risk drawdown in the medium term is 25%, and they are only comfortable with half that level, then half should be invested in cash, simple as that. The worst thing that could happen is that they experience the drawdown, panic and sell out, right at the bottom. This is exactly what causes people to go against the logic of buying low and selling high. They buy high (when things look great) and sell low(in panic).
Charles/Olikea - As I get older I am finding that I have less tolerance for drawdown. 100% in illiquid smallcaps doesn’t cut it for me any more. There is something to be said for slow growth and seeing your account increase in size every month. There are alternatives to cash including many new ETFs recently introduced that tend to appreciate over time, some are less correlated to the stock market. I now hold a fair portion of my capital in such things as agribusiness (MOO), agriculture commodities (DBV), sovereign debt (PCY), international treasury bonds (BWX), timber (CUT), gold (GLD), etc… Now this being said, I do get aggressive with my investments this time of year and will probably shift my money into some high performing P123 ports for end of December through March.
Steve
This is a great discussion. I agree with so much about what has already been said. Here is another factor to consider:
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Some time ago, John Mauldin’s newsletter had a link to a study showing that 75% of the people who retire with 1 million will likely end up with accounts of 5-10 million when they die. However, about 5-10% will end up broke at age 80 and would have to go to work as a greeter at Walmart. Everyone is assumed to have started retirement with 1 million and to draw the same amount out each year. The difference was the timing of a big market DD. If it happened shortly after retirement, big trouble. But if the DD came after 10 years or so, the retirement account had doubled or tripled even after withdrawals. and was thus able to withstand the big DD and resume growing. The above numbers are by memory and thus are not precise, but they illustrate the general idea.
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The point I took away was this: I will either have way more money than I need, or not enough. If I try to retire when I have “just enough” to live comfortably, I am taking a 1 in 10 risk of going broke.
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So My goal is not retire until I have at least 4 times the money I need. Why? Because the market might take a 50% dive just after I retire. And after such a dive I will need to have twice what I need to have the courage to keep my money in the market. Actually I would prefer to have 8 times what I need. That may seem excessive, but when I retire I will not have a pension (other than the government one, if it still exists) so I will need to live entirely on my investments.
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An additional approach I am considering for retirement is to keep the next 3 years living expenses in cash. Thus if the trading account takes a dive, it will have 2-3 years to recover before I take another withdrawal. Keeping that much in cash (eg, T-Bills) will reduce my overall returns but it will let me sleep better at night and reduce the temptation to overreact to a market crash.
Hi,
My goals include maximum returns, limited drawdowns, and minimum time to manage my investments. What can I say, maybe I’m greedy but I don’t think these goals are mutually exclusive. I don’t consider 50% drawdowns acceptable, my goal is to stay below 25% drawdowns and I am willing to give up some annual return to do so.
I disagree. Certainly finding fundamentally sounds stocks reduced the risk during the last Bear. Diversification can also reduce drawdowns. Diversification among investment strategies is also useful and has helped me this year. A simple concept of diversification between stocks, bonds, gold and cash has worked well since the 70’s. The Permanent Portfolio Fund (PRPFX) is based on this concept and has had roughly 9% annual returns + dividends over the past 10 years with a max drawdown of roughly 10%. This is near stock market returns in the long run (much better over this time frame) with significantly less risk. I keep about 25% of my overall portfolio in such conservative investments, about the same as what I have in my aggressive P123 investments.
Don