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A Walk Down Drawdown Lane

Validea

Contributor:
Validea
Visit: Validea

By:

President at Validea.com & Co-founder of Validea Capital Management

With the S&P 500 hitting all-time highs, it might seem strange to write an article about market drawdowns, but the one thing we know for certain in markets is at some point stocks will fall, and possibly by a good amount. Investors that are mentally prepared for these declines – and understand that market drawdowns are a normal part of investing in the stock market – are likely to be in a better position not to make mistakes with their portfolio when these declines inevitability occur. 

40 Years of Market Drawdowns

The chart below, courtesy of Calamos Investments, shows the calendar year returns (in dark blue) along with the intra-year drawdowns (green) for the S&P 500 from 1980-2020. There are some interesting observations.

  1. There was never a year where there wasn’t a drawdown. So over each calendar year, there was some downside to stocks investors would have had to deal with.
  2. Out of those 40 years, there were 7 years where the stock market didn’t produce a positive calendar year return and 33 years in which the returns were positive.
  3. In 21 out of 40 years, the market saw intra-year declines of more than 10% but in 62% of those years the market ended the year with a positive return.
  4. The largest intra-year decline was during the Great Financial Crisis (2008) with a 48% drawdown. That is followed by a 34% decline in 2020 and a 33% decline in 2002. The returns for the market after those years proved to be very strong for stocks.
S&P 500 Market declines in perspective, even up markets see drawdowns

Source: Significant Intra-Year Drawdowns Are Common, Calamos Investments

No Pain, No Gain

One of the reasons individual stock-picking can be so difficult is because many individual stocks generate more frequent and more painful drawdowns, which makes holding on during these periods very difficult for many. Take for example, the stock of Monster Beverage, which many investors may not know, has outperformed Amazon and Apple since Amazon went public in 1997.

stock of Monster Beverage has outperformed Amazon and Apple since Amazon went public in 1997.

But the ride would have been far from easy as you can see from Monster’s drawdown chart below. Monster was effectively a penny stock in its early years but even when it was a more established company starting in the mid-2000s, it still fell, and by a lot and often. It declined close to 45% twice and was down 70% during the GFC. Since investors feel losses twice as much as gains, dealing with this type of downside volatility is very difficult for many investors. And this isn’t unique to Monster. If you look at many stocks, and even the very best performers, you will see drawdown charts similar to this one.

Monster’s drawdown

Source: https://www.grufity.com/stock/MNST-monster-beverage/Risks

Dealing With Drawdowns

There are a few things investors can do in an effort to deal with drawdowns. Of course, asset class and portfolio diversification are the most obvious solutions – if you are properly diversified across multiple asset classes or hold a diversified equity portfolio, you are removing some of the drawdown risk of concentration or individual stock exposure. Also, methods such as stop losses on individual positions or using techniques such as trend following to move out of stocks based on the use of moving averages can help protect against drawdowns, but those also come with risks of being whipsawed or having to chase the market back in if you are wrong. Lastly, and I am not sure this is the best advice is just don’t look — if you are continuously refreshing your accounts and tracking your investments too frequently there is a chance you’ll make bad, overly emotional decisions. With that being said, you can’t just totally ignore things all together either.

Ultimately it comes down to each investor and the maximum loss they are willing to accept with their investments. Those investors who have a good sense of their maximum drawdown threshold and can build a portfolio that helps protect them from hitting that redline will be the ones best positioned when the inevitable downturn comes.

Originally Posted on August 25, 2021 – A Walk Down Drawdown Lane

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