Investors must accept their stocks will be underwater from portfolio high watermarks most of the time.

What are drawdowns?

It measures the peak-to-trough decline in the value of a portfolio before a new peak is achieved.¹ A maximum drawdown (MDD) is the maximum loss of an investment during a specific period and is highly relevant as it is an important indicator of downside risk.²

MDD(T) = (P-L)/P

P = Peak value before largest drop    L = Lowest value before new high established

Source: “The Formula: Maximum drawdown” (2018). Robeco

Stocks do not make new highs every day and so the outcome is the investor is usually in a drawdown state.

Historical evidence

Risk is a constant and the analysis of drawdowns across the main indices over long timespans provides a tangible representation of this inherent exposure. Unsurprisingly, when analysing drawdown data from the FTSE All-Share Index (FTSE) and the S&P 500 the same overarching conclusion materialises. Losses are constant and frequent, and can occur under any economic conditions and cycles.

The FTSE

UK stock market drawdowns for the period from 1969 to 2017 show regular and significant peak-trough declines across all decades.³

When utilising two data sets, the ‘extreme’ and the ‘natural’ state, is it only then possible to appreciate the importance of drawdowns and its potential impact on the investor both financially and psychologically. As such, Table 1 quantifies the most severe crashes during the period under review, whilst Table 2 quantifies the drawdown state, being the consequence of recurrent stock market corrections.

Table 1: Maximum Drawdowns

Source: “The psychology of drawdowns” (2017). The Harriman Stock Market Almanac

Table 2: Drawdown State

Source: “The psychology of drawdowns” (2017). The Harriman Stock Market Almanac

The two tables, especially when viewed in tandem, highlights the two main challenges the investor has to overcome when considering drawdowns (i) the inevitability of material crashes on a cyclical basis and (ii) the drawdown state is time abundant with declines greater than one-fifth of the peak prevailing for 27% of the time.

S&P 500

US stock market drawdowns for the period from 1927 to 2016 also show regular and significant peak-trough declines across all decades.⁴

By far, the most extreme MDD occurred in the US during the Great Depression, which stemmed from the Wall Street Crash. Similarly, to the FTSE analysis Table 3 quantifies the most severe crashes during the research period, whilst Table 4 quantifies the drawdown state.

Table 3: Maximum Drawdowns

Source: Carlson, B (2018). “180 Years of Stock Market Drawdowns”. A Wealth of Common Sense

Table 4: Drawdown State

Source: Chandra, T (2016). “Living In A Drawdown State – 60% Of The Time”. Seeking Alpha

Similarly, as with the FTSE, the two tables highlight the same challenges to the investors with remarkably familiar MDDs when comparing the same crashes. Notwithstanding, the drawdown state from 5% upwards is 63% of the time for the FTSE compared with 49% for the S&P 500; the two indices both have in common the drawdown state is the most likely scenario at any point in time. So much so, Robert Frey concluded the time spent underwater from the last high watermark to be nearly 66% when interrogating the S&P 500 across this period, leading him to call it the “State of Regret”.⁵ As mentioned previously, the psychological impact on the investor is relentless, hence, Frey’s rather unceremonious drubbing of the condition on the investor.

Conclusion

By analysing two of the key global indices over long periods, it is clear that drawdowns are the less palatable facet of stock market investing, but an inevitable trait. Investors must therefore accept, and by default appreciate, that it is through these corrections inefficiencies materialise and in turn create opportunities. If we were to extend this analysis to other global indices, one could be confident of the outcome replicating again. Furthermore, whilst accepting of the common view that emerging market stocks are priced more inefficiently when compared with those in the more developed markets of the US and UK and consequently providing a heightened potential for better opportunities, the question remains - is it at the price of greater drawdown exposure?

At a granular level, we can see a similar pattern and even the world’s largest market cap companies are not immune. By taking for example, Apple Inc. and Amazon.com Inc. both with current market caps of circa USD800BN and traded on NASDAQ. Since Apple’s IPO in 1980 there has been two separate 82% drawdowns, one from 1991 to 1997 and another from 2000 to 2003. Amazon’s IPO was in 1997 and only two years later in September 2001 the company suffered a 94% drawdown. The same can be said for Microsoft Inc. and Alphabet Inc. (Google is a subsidiary) who have experienced MDDs of 70% and 65% respectively during their history. Lastly, as well as these severe crashes, which are distinguishable with the markets, these companies have also experienced peak-trough declines across all decades.⁶

In summary, drawdowns are very influential and can pose a significant threat to the positive investor journey. Stock market drawdowns cannot be eradicated, but can be managed, and therefore one is reminded of the need to protect the resilience of an investment portfolio, if nothing more to successfully navigate through the crashes and the ongoing drawdowns described above. By recognising the need for stability and sustainability during portfolio construction, investments with no or low correlation to capital markets and a high degree of capital preservation will play a vital role to counteract drawdowns and suppress Frey’s so-called, State of Regret.

Notes

References