Saturday 1 March 2014

Do Drawdowns Matter?

In the last few blog posts, I've discussed that volatility is your friend in portfolio management. The greater the volatility of a particular stock index or bond, the higher is the eventual portfolio value. However, I have not addressed a pertinent point, which is that drawdowns do happen during the course of the portfolio. The figure below shows the performance of a portfolio comprising 70% stocks and 30% bonds over the last 26 years.

Drawdown in Portfolio Value

Although the final value of the portfolio is 3.3 times the initial value and is close to the highest value achieved, it has gone through several drawdowns, the most significant of which occurred during the Global Financial Crisis, when the portfolio value dropped by 44% from the peak. Are drawdowns of importance to investors? It depends on the risk profile of the investor.

For investors who are risk-averse and are fearful that their portfolios lose money, drawdowns matter significantly. They could force such investors to sell out before the portfolio regains its previous value. Such investors would be better off investing in lower-volatility portfolios so that they can see through the drawdowns and realise the eventual but smaller gains in the portfolio.

However, for aggressive investors, drawdowns matter little. Such investors know from history that drawdowns are usually temporary and are necessary for portfolio rebalancing to achieve a higher portfolio value in the future. In fact, they create rare opportunities for investors to invest more in the portfolio. Such opportunities could generate large returns and come only once in several years.

There are some portfolios which are specially constructed to minimise drawdowns so that investors can stay the course and realise the eventual gains. I do not have a good answer to drawdowns. You have to decide whether you prefer a higher eventual portfolio value and hence have to accept higher volatility or you cannot live with volatility and hence have to content with lower portfolio value. You just cannot have your cake and eat it.

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