Using Drawdown Analysis To Minimise Loss In Portfolio Management

Using Drawdown Analysis To Minimise Loss In Portfolio Management

By Wires | The Trent on February 27, 2018
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portfolio management

A large-scale drawdown has the potential to wipe out a sizable portion of your investor’s portfolio and is therefore a cause for concern. In addition to heavily eroding your capital, a large drawdown also shakes your confidence to the core. In many cases, it has caused investors to throw their hands in the air and give up on investing altogether.

The primary risk of any investment is losing your principle, but many investors fail to fully appreciate how potentially devastating large-scale drawdowns can be on the returns in the long term.

Understanding drawdowns

In simple terms, a drawdown is the percentage decline of an asset from its peak to its lowest value within a specified duration. The measurement can be used for stock portfolios as well as portfolios of other assets, such as cryptocurrencies. However, it is most commonly used to measure the risk of a portfolio.

Analysis and minimization of the size of drawdowns is essential to ensuring you reach your investment goals. Drawdowns cause investors great anxiety because the gain required to restore your portfolio to its initial peak after a drawdown grows exponentially. For example, an 11% gain is required to fix a loss of 10%. The required gain expands to 25%, 67% and 300% for losses of 20%, 40% and 75% respectively.

A drawdown can therefore escalate from being no cause for worry to being devastating in an unexpectedly short period, destroying months or even years of growth. It is for this reason that you need to learn how to correctively analyze and mitigate the risks associated with large scale drawdown by visiting top investment sites such as foxytrades.com

Whether you choose to become a part-time or full-time investor, you will realize a short while after starting out that bear markets (periods of loss-making) are an inevitable part of any investor’s journey. This is true not only for individual and institutional investors, but for the stock market as a whole.

The US stock exchange, for example, has gone through serious financial upheavals on average of every four or five years in the course of the past 200 years. In fact, some bear markets have lasted as long as two decades.

One of the tenets of successful investing is protecting your principal from bear markets. Too many investors lose out because they fail to include a drawdown analysis in their investment strategy. It is often the case that an investor becomes excited after achieving especially impressive returns, only to have all the returns and a sizable chunk of their principle wiped out by sudden drawdown.

Maximum drawdown

Maximum drawdown of a portfolio is the maximum peak-to-trough loss before the portfolio reaches a new peak. Maximum drawdown serves as an indication of your portfolio’s downside risk of a given duration. Experienced investors reliably use it as a stand-alone measure of risk or in conjunction with other metric such as the Calmer Ratio and Return of Maximum Drawdown.

Expressed as a percentage, the formula for maximum drawdown is as follows:

            Maximum drawdown (MDD) = (Peak Value – Trough Value) / Peak Value

The primary focus of maximum drawdown is preservation of capital. It is an indicator of the risk of a stock screening relative to another. Two screening strategies may have identical average volatility, tracking error and outperformance. However, they may have difference maximum drawdowns with respect to the benchmark.

Important to note is that while the maximum drawdown measures the largest loss, it does not take into account the frequency of the losses. As a result, the maximum drawdown provides no information about the duration it took to recover the loss, if at all it the investment was at all recovered.

Needless to say, low maximum drawdowns are preferable because they mean you incurred only small losses. To get the most out of a maximum drawdown, you should interpret it in the right perspective. For example, while the maximum drawdown of your portfolio might seem sizable at first glance, an investor’s view of it can change in light of the fact that it is lower than the maximum drawdown of the entire market. This means the portfolio outperformed the market.

Managing risk using drawdown analysis

Many investors allow themselves to be driven by greed, especially when the prices of stocks begin to soar. More often than not, your emotions will make you want to join the herd as you compare the returns of your portfolio to those of the indices. Furthermore, your friends, colleagues or fellow investors indirectly pressure you by boasting of their high returns.

In the above circumstances, it is essential to keep a clear head and remember that the likelihood of drawdowns increases greatly during periods of high valuations. Therefore, avoid falling for the trap of fixating on returns. In such times, capital preservation should be your top concern because you need to protect your downside.

One of the goals of every experienced and successful investor is to allocate portfolio assets by coupling non-correlated assets in order to optimize profits within the maximum drawdown the investors are willing to tolerate. Proper allocation of assets involves determining the amount of non-correlated assets to include in the portfolio.

Among the measures of risk that are highly useful in portfolio management is standard deviation. Familiarizing yourself with standard deviation is crucial because assessing probabilities is the foundation of risk management. However, instead of only fixating on investment risk, you should also consider your portfolio’s maximum drawdown risk.

Conclusion

Making money in a bullish market is easy even for novice investors. The real challenge of portfolio management is navigating around large scale drawdown in bear markets. Not even the most experienced investors can consistently predict the market. Still, star investors make use of the ample historical data available on all previous bear markets that followed high valuations.

As a result, valuation timing has become part of the first line of defense of investment capital for modern investors. Always keep in mind that effective portfolio management is about not only making impressive profits, but also protecting your investment from major losses. Managing your risk through drawdown analysis ensures you reach your long-term investment goals.

Timothy Sykes has been as a star live trader in the stock market for more than a decade. He has made himself as well as numerous other investors wealthy through a unique investment strategy that has outperformed the strategies of even the most experienced traders. Find out more by visiting http://foxytrades.com/.

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