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This chapter is from the book

Drawdown: The Measure of Ultimate Risk

Figure 1.3

Chart 1.3 Closed Drawdowns by Volatility
Drawdown represents the maximum loss taken from a peak in portfolio value to a subsequent low before a new peak in value is achieved. The highest-volatility group, Group 9, incurred losses of as much as 68% during the 1983–2003 period, whereas the lowest-volatility group, Group 1, had a maximum drawdown of just 15%.

Drawdown, the amount by which your portfolio declines from a peak reading to its lowest value before attaining a new peak, is one of the truer measures of the risks you are taking in your investment program.

For example, let us suppose that you had become attracted to those highly volatile mutual funds that often lead the stock market during speculative investment periods, and therefore accumulated a portfolio of aggressive mutual funds that advanced between late 1998 and the spring of 2000 by approximately 120%, bringing an initial investment of $100,000 to $220,000. So far, so good. This portfolio, however, however, declines by 70% during the 2000–2003 bear market to a value of $66,000. Although losses of this magnitude to general mutual fund portfolios previously had not taken place since the 1974 bear market, they have taken place during certain historical periods and must be considered a reflection of the level of risk assumed by aggressive investors. Moreover, this potential risk level might have to be increased if asset values for this portfolio and similar portfolios were to decline to new lows before achieving new peaks, which had not yet taken place during the first months of 2004.

Protracted gains in the stock market tend to lead investors to presume that stock prices will rise forever; buy-and-hold strategies become the strategy of choice. Interest focuses on gain. Potential pain is overlooked. (Conversely, long periods of market decline tend to lead investors to minimize the potential of stock ownership. The emphasis becomes the avoidance of pain; the achievement of gain seems hopeless.)

Drawdowns—and risk potential—decline dramatically as portfolio volatility decreases, although risks to capital are still probably higher than most investors realize, even in lower-volatility areas of the marketplace. For example, maximum drawdowns between 1983 and 2003 were roughly 16% for Group 2, the second-least-volatile group of mutual funds, rising to 20% in Group 3, a group of relatively low volatility. Mutual funds of average volatility, Group 5, showed drawdowns of 35%.

In evaluating mutual funds or a selection of individual stocks or ETFs for your portfolio, you should secure the past history of these components to assess maximum past risk levels. ETFs (exchange traded funds) are securities, backed by related baskets of stocks, which are created to reflect the price movement of certain stock market indices and/or stock market sectors. For example, there are ETFs called SPYDRS that reflect the price movement of the Standard & Poor's 500 Index, rising and falling in tandem with the index. Another ETF, the QQQs, reflects the Nasdaq 100 Index. There are ETFs that reflect a portfolio of high-yielding issues in the Dow Industrial Average, a real estate trust portfolio, and even an ETF that reflects a portfolio of 10-year Treasury bonds. In many ways, ETFs are similar to index- or sector-based mutual funds, have the advantages of unlimited trading at any time of the day, as well as lower internal expenses than mutual funds. There are certain disadvantages, however, mainly associated with bid-ask spreads, which add to transaction costs as well as occasional periods of limited liquidity.

You can fine-tune the total risk of your total portfolio by balancing its components to include lower-risk as well as higher-risk segments. For example, a mutual fund portfolio consisting 50% of intermediate bond funds (past maximum drawdown 10%) and 50% Group 8 mutual funds (past maximum drawdown 50%) would represent a total portfolio with a risk level of approximately 30%, probably as much, if not more, risk than the typical investor should assume.

The End Result: Less Is More

Figure 1.4

Chart 1.4 Twenty Years of Results, Based on Volatility Group
All things considered, investors gain little, if anything, by placing investments in higher-risk holdings. Lower-volatility groups have provided essentially the same investment results over the long run as higher-volatility groups, but with much less risk.

Chart 1.4 pretty much tells the story. With the exception of mutual funds in Group 1 (which includes many hybrid stock, bond funds), equity and balanced mutual funds of relatively low volatility produced essentially the same returns over the 1983–2003 decade as mutual funds of higher volatility. Generally, the highest average returns were secured with mutual funds of approximately average volatility, where the curve of returns appears to peak. However, differentials in return between Groups 2–3 and Groups 4–6 might or might not justify the increases in risk that are involved in stepping up from the very low-volatility groups to those at the average level.

To sum up, for buy-and-hold strategies, higher volatility has historically produced little, if any, improvement in return for investors, despite the greater risks involved. These actual results run counter to the general perception that investors can secure higher rates of return by accepting higher levels of risk, an assumption that might be correct for accurate and nimble market traders during certain periods but, in fact, is not the case for the majority of investors, who are most likely to position in aggressive market vehicles at the wrong rather than the right times.

Lower-volatility mutual funds typically produce higher rates of return and less drawdown, something to think about.

In as much as accurate timing can reduce the risks of trading in higher-velocity equities, active investors can employ more volatile investment vehicles if they manage portfolios in a disciplined manner with efficient timing tools. Relative returns compared to lower-volatility vehicles improve. Aggressive investors with strong market-timing skills and discipline might find it worthwhile to include a certain proportion of high-velocity investment vehicles in their portfolios—a certain proportion, perhaps up to 25%, but not a majority proportion for most.

Again, we will continue to consider tools that will improve your market timing. However, before we move into that area, I will show you one of the very best strategies I know to maintain investment portfolios that are likely to outperform the average stock, mutual fund, or market index.

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