Most people when asked that question will probably think “I don’t need to worry about that”. A 50% drawdown sounds unlikely hey. Well it’s not as unlikely as we may think. If you ask the best investor of all time that question, Mr Warren Buffett, he could honestly reply that he physically has done so, twice in the last 20 years. Incredible.
Even if we take a look at the FTSE 100 it has suffered two plus 48% drawdowns in the last 20 years, and the S&P 500 suffered a whopping 86% drawdown during the great depression.
What do we class as a drawdown?
I suppose we should just check we are all on the same page when it comes to drawdowns of our trading/investment accounts. A drawdown is classed as a percentage calculation of the difference between the peak value to the following lowest value of our account.
A common Meb Faber quote is that our accounts are only ever in two states. At a new high or in drawdown. This gives food for thought but a 50% drawdown thankfully is few and far between.
Many long term buy and hold investors will suffer 50% drawdowns in their accounts at some point and this creates huge issues. Many people can take a 20% drawdown, even a 30% drawdown but much further and the fear/greed/panic causes them to sell or change strategy. A massive problem with this is that it causes us to sell at the worst time, often the markets recover and we never have the chance to recoup those losses.
The most recent major drawdown period was during the ‘credit crunch’ financial crisis of 2007-2009. The FTSE 100 peaked at 6751 in 2007 and fell to a low of 3460 in 2009. If we were simply invested in equities during this period our accounts would have halved. Take a second to imagine the pain of this.
So what are our options?
Well the way I see it, we either hope for the best and believe we can stick with the strategy if we hit a 50% plus drawdown or we try to reduce the risk of such a drawdown by altering our strategy.
We can do this in a few different ways. We can introduce various asset classes that do not correlate therefore when one asset is on the slide, a different asset is on the up. Another option is to introduce trend following into our strategy so we try to get out before the big losses occur. Or how about, as I do, we combine these and potentially even introduce short selling into the mix.
So what would have happened with my long term trading strategy during the 2007 – 2009 ‘credit crunch’?
Well my backtests show my net profit would have increased by 52% over this period. That is a huge difference but don’t get me wrong my strategy does suffer drawdowns. It’s losses occur at different times to the general equities market. These drawdowns are however not the huge scary drawdowns that we would have to suffer with a simple buy and hold investment strategy. The biggest drawdown of late was a 27% drawdown between October 2014 and November 2015 when markets were whipsawing. Nobody likes a 27% drawdown however it’s a lot easier to stomach than 50%.