Last Updated on March 6, 2021 by Oddmund Groette
If you can’t stomach 50% declines in your investment, you will get the mediocre returns you deserve.
The share price of Berkshire Hathaway has declined more than 50% at least three times: Once during the inflationary period in the 1970s, once from 1998 to early 2000, and the last time in 2008. Furthermore, Berkshire has underperformed the S&P 500 for at least the previous six years from 2015 until 2021. Yet again, in 2020/21, Warren Buffett has seemingly lost his magic touch.
Despite this, Buffett and Charlie Munger have managed almost 20% annual returns. At intervals of 5-8 years, Berkshire has suffered significant setbacks in the share price without the duo losing their self-confidence and faith in their investment philosophy.
Drawdowns are probably the risk that makes most traders fiddling, changing, or abandoning their strategies. Thus, a good trading plan deals with drawdowns before they inevitably happen. Our anecdotal experience indicates most traders and investors (including ourselves) underestimate their risk tolerance. What looks tolerable in backtesting is not as straightforward when dealing with real money and real losses. This article looks at ways to deal with inevitable drawdowns: trade small, trade many markets and time frames, but above all, make sure you trade within a wide margin of risk tolerance.
Trading vs. investing
To avoid drawdowns, many switch from long-term investing to short-term systematic trading.
Even though Buffett has managed almost 20 a year, the price he pays is an enormous drawdown at odd intervals. That’s why you are a trader and not a long-term investor! Surely you can minimize drawdown by short-term trading and market timing?
Unfortunately, no matter your time frame you can’t eliminate risk. Even The Medallion Fund, the world’s best performing fund, was on the brink of collapse in 2007 despite its steady gains and high Sharpe Ratio. Don’t fool yourself into believing the financial markets offer you easy money. They don’t, and you’ll get kicked in the teeth when you least expect it.
What is a drawdown? How is drawdown calculated?
First, we need to define what a drawdown is.
A drawdown is the difference between the peak to trough of your capital/equity. Let’s assume you invested 100, and your portfolio is worth 118 after some months. After the peak, you suffer some setbacks, and the value falls to 105 before it resumes rising. Your drawdown was 13, or 11%.
We have two types of drawdowns: closed and open. Closed drawdowns are the drawdowns measured from close to close, while open drawdowns include the intraday drawdown between the closing prices. These two types might differ, primarily if you use leverage. Nassim Nicholas Taleb writes that you shouldn’t cross a river that is on average four feet deep. Likewise, the close to close drawdown might fool you into unrealistic expectations when intraday drawdown might force a margin call.
An overlooked issue of drawdowns is the length of it. As described above, the extent is measured in percentage, but the length is measured in days, weeks, or months. You might not suffer an extensive drawdown in percentage, but as months go by without winning, the daily grind gradually withers your confidence.
Some strategies have a high win-ratio with many small winners and occasionally big losers. Mean revertive strategies fit this description. Opposite, some trend-following systems have a low win ratio with many losing trades but a few big winners. Trading often involves alternatives, and you need to evaluate how you deal with such issues and how to overcome them.
Why are drawdowns important?
Drawdowns are the reason traders quit:
- Has the system stopped working? You hesitate and stop.
- Is this the beginning of a larger drawdown? You are unsure and stop.
- Am I doing something wrong? You pause the strategy and alter the variables before resuming (with a new strategy)
These simple three reasons should always be in the back of your mind in the development process. What is your tolerance for these kinds of risks? Drawdowns increase the risk of behavioral mistakes. Will you still have faith in the system after a losing streak? When real money is at stake, the answer might not be evident because you never know if the drawdown is temporary or permanent.
Not only does a drawdown damage your confidence, but you face the risk of permanent loss of capital. A significant drawdown reduces your capital. A 50% drawdown requires a 100% return to get back to even. A 75% drawdown means you need to grow your remaining capital 400% to get back to former glory. You get the picture.
Drawdowns and the Sharpe ratio
Drawdowns are an essential tool for comparing strategies and performance. The chart below shows the performance of Brummer & Partner’s return since 2002 (red line) and the MSCI World Index (grey line). Both have almost the same CAGR, but Brummer’s returns have been smooth with minor variations:
Which investment would you choose – Brummer or MSCI? It’s safe to say the great majority would choose the red line (Brummer’s return). The reason is simple: it offers the least amount of pain going from A to B.
Given two alternatives with the same CAGR, most traders and investors chose the one with the smoothest returns, ie. the one with the minor drawdowns and variations in the return. However, this doesn’t mean you shouldn’t include strategies with significant drawdowns. The reason why Brummer has managed smooth returns boils down to trading many markets and time frames. You should do the same.
A mathematical way of measure the quality of the return is the Sharpe ratio. A high Sharpe ratio is preferable to a lower one. However, many funds “blow-up” even though they have many years, even decades, of low volatility and high Sharpe ratios.
What is an acceptable drawdown? Drawdowns are inevitable
Looking at the 15-year records of all the actively managed U.S. domestic equity funds that existed at the start of 1998, we find that not only are long-term outperformers rare, accounting for only 18% of those funds, but they also experience numerous and often extended periods of underperformance. Indeed, nearly every one of the successful funds underperformed in at least five of the 15 years through December 2012. Furthermore, two-thirds of them experienced at least three consecutive years of underperformance during that span. We conclude from this analysis that investors pursuing outperformance not only have to identify winning managers, but historically have had to be very patient with those managers to collect on their success.
To be a long-term winner, you can’t always be a short-term winner. Despite the psychological damage related to severe drawdowns, you may seek comfort in the fact that drawdowns are inevitable. Trading is difficult because we prefer steady gains, but the market offers only random lump-sum rewards. On Twitter, you might look at other traders that seemingly never seem to have a losing trade. But don’t fool yourself!
Setbacks are part of life. It’s how you deal with setbacks that eventually determine if you end up ahead or quit at a trough in your equity curve. It’s logical: if you want smooth risk-free returns, you get returns close to zero. Anything above that involves risk, and the risk comes in the form of drawdowns. No one likes to lose, but you can’t expect to win all the time. You have to endure short-term pain to get long-term gain.
Don’t avoid drawdowns – accept them and use them to your advantage
Many traders manipulate strategies by adding variables or setting unrealistic parameters. The result is a curve-fitted backtest. However, drawdowns are inevitable. Don’t ignore a strategy just because of its drawdowns. The reason some strategies work is because many abandon ship at the bottom of the cycle. Use that to your advantage by accepting and managing drawdowns. As a rule of thumb, the more frequent drawdowns in a strategy, the more likely it’s to stand the test of time. A strategy with small or insignificant drawdowns is more likely a result of chance, randomness, or curve fitting.
Most strategies stop working
Nothing lasts forever, and certainly not in the financial markets. Markets change and evolve. It’s natural that edges disappear and grind to an end. Very rarely does a strategy “blow-off”. If you know why a strategy works, you stand better chances of knowing when it stops working.
How to deal with and reduce drawdowns
No matter how prepared you are, a drawdown makes even the most confident traders unsure and nervous. You should aim for small drawdowns to avoid behavioral mistakes, but not by turning good strategies into perfect ones. Think holistic when it comes to drawdowns.
Below we bring forward some arguments we believe you should keep in mind before you start trading:
Align your trading style with your personality
It helps if you trade with conviction and self-confidence. For example, so-called trend-following strategies in the commodity markets have always required huge drawdowns and many years of underperformance to reap the historically high returns. Are you able to execute your strategy after ten losers in a row? Are you able to stick to the strategy after two losing years in a row? Most traders can’t. No backtest prepares you for setbacks that make you stop or altering your strategies – at the exact wrong moment. How many percentage points of drawdowns can you tolerate? 10%? 30%? 40%? Only trade strategies you are confident to follow.
You don’t get successful by copying the trading style of someone else. Noise and random movements make sure you quit at the worst moment if you have not spent time dealing with the systems on your own.
Trade many strategies
Never rely on just one strategy – make sure you have many strategies.
Trade many markets
There is no help in trading many strategies if they are all pretty similar in length, type, and market. Correlation between asset classes increases when volatility picks up, but some markets might go in opposite directions, like bonds and gold.
Trading the short side is difficult, but they might offer uncorrelated returns even though their total returns might not be so attractive.
Trade different time frames
Even during an extended bear market, you can make money on the long side via day trades that are often uncorrelated with the market’s overall trend. Different time frames are an excellent tool in creating uncorrelated strategies.
Trade small size and stay well within your comfort zone
Always trade smaller than you’d like and within a wide margin of safety of your comfort. Too many traders get greedy and trade too big size- which often backfires.
For example, assume your strategy has historically had a drawdown of 40%, which is way too big for most traders to handle, no matter how high the annual returns are. Instead of ignoring the strategy, trade small and allocate less capital than what you otherwise would do. The beauty of automated trading is the ability to trade an almost infinite number of strategies. Use that to your advantage!
When you add a strategy to your portfolio, make sure it adds diversification and is uncorrelated with the other strategies
Simulate how your portfolio of strategies has performed before you go live with it. A good stand-alone strategy doesn’t necessarily add much value to an overall portfolio because of overlapping trades. Opposite, a mediocre strategy might add more value to the portfolio because of diversification. Don’t look for the holy grail, a portfolio of sub-optimal strategies might perform very well together.
The biggest drawdown is yet to come
Always assume that the drawdown in live trading turns out to be bigger than your backtest indicates. No matter how simple your strategies are, every backtest involves a little bit of curve-fitting. Always assume the “worst”. The biggest drawdown is yet to come.
In trading and investing, drawdowns are inevitable. No pain, no gain. Look at drawdowns as the cost of doing business and use them to your advantage by trading smaller than you normally would do. Don’t throw away strategies with huge drawdowns – they might offer value in the form of correlation and diversification. Make sure you trade many markets and time frames.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.