Last Updated on July 31, 2022 by Oddmund Groette
180 Years of Stock Market Drawdowns
In a presentation to the Institut des Hautes Études Scientifiques (IHÉS), termed An Analysis of 180 Years of Market Drawdowns, which is available on YouTube, Dr. Robert J. Frey, a former hedge fund manager and quant trader (whose firm was actually bought out in the 90s by the legendary hedge fund manager Jim Simons), discusses market drawdowns and uses different models to show that they have been the same over the years. But what are market drawdowns, and how often do we have them?
For any given trading period, prices inevitably show peaks and valleys. So, a drawdown is the change in price from one market peak to the next market valley. It is a peak-to-trough decline during a given trading session, which can be daily, weekly, or monthly, and it is usually quoted as the percentage of the market peak. There have been several market drawdowns over the last 180 years, and it seems drawdowns are the most constant factor in the market.
Let’s take a look at the key points of Dr. Frey’s analysis, but first, let’s define market drawdowns.
What are stock market drawdowns?
As you know, the market shows peaks and valleys for any given trading period. A drawdown is simply the total change in price from one market peak to the next market valley. It is a peak-to-trough decline during a given trading session, which can be daily, weekly, or monthly, and it is usually quoted as the percentage of the market peak. On the monthly timeframe, the drawdown can be from less than 5% to more than 20%. That is, in a month, there can be more than a 20% drawdown.
When the price of a security falls below the highest and then rises again during that trading timeframe, a drawdown is recorded. As expected, the longer the price of a security stays below the last peak, the more the possibility of a lower trough, thus increasing the amount of drawdown. To establish that a drawdown is over, the price has to again crosses the highest peak earlier witnessed.
Having a good knowledge of drawdown is crucial to managing market turbulence, gauging volatility, and measuring the inherent risk associated with a security and an investor’s potential losses. Drawdowns represent the largest loss an investor can potentially experience during that trading timeframe. But it is different from an actual loss, which is computed as the difference between the purchase price and that at which an asset is bought or sold in the market.
Looking at the market over a period of 180 years
In the words of Dr. Frey, “We tend to be inadequate historians.” Market drawdowns are more common than we think, and they seem to be fairly consistent over the years. In fact, while the usually logarithmic charts of the US stock market tend to show sustained growth over the years, drawdowns are the most consistent thing in the market.
According to Frey, risks (specifically, drawdowns and losses) are one constant in the market going back all the way to the early 1800s. He presented a couple of different charts on the market and used different statistical models, such as linear regression and Lomax distribution to make his point.
First, here’s the long-term growth of the US stock market (drawdowns are shaded in red and logarithmic chart):
When he pulled out and looked at the drawdowns, he could see the drawdowns everywhere and of different sizes, as you can see in the chart below.
In his words, “You’re usually in a drawdown state.” It could be a 5%, 10%, or 20% drawdown, and the duration can vary — from a month to many years, as in the crash during the Great Depression. From the chart above, you can see how consistent losses have been over each and every decade or economic environment. Drawdowns are really the one constant across all cycles.
With a linear regression model, Dr. Frey could demonstrate that the size of the drawdowns is proportional to the duration of the drawdowns.
But while the duration of the drawdowns varies, there have not been fewer drawdowns in recent years, despite all the changes introduced into the market over the years.
Changes that have taken place over the last 180 years
Many regulatory changes have been made in the US stock market since the 1800s, as Dr. Frey points out. Some of them include the creation of the Fed, monetary policy, fiscal policy, the end of the gold standard, tax rates, valuations, the industry make-up of the markets, and a number of other things, such as the introduction of circuit breakers to curtail flash crashes.
But in spite of all these changes, there have been no significant changes in the frequency of drawdowns over the 180 years period.
Drawdowns are constant
As Frey pointed out, drawdowns are one constant thing in the market over the years. According to him, investors at any point in time are at a 75% chance of being in a drawdown state. In other words, one spends about 75% in a drawdown, and what is mindboggling is that more than half of that time is spent in a major drawdown, which he defined as a more than 20% drawdown.
Since stocks don’t make new highs every single day or even month, most of the time, an investor is underwater and in a state of regret when investing in stocks. This shows the importance of emotional control and developing the right psychology when investing in stocks.
It’s easier to predict risk than returns
Experience has shown that it is practically impossible to predict what the future returns will be in the stock market — no one knows what the future holds for economic growth, and neither can anyone predict how investors will decide to key economic and market indices at any point in the future.
But if there is one thing we can predict about the market, it is the risk — the markets will continue to fluctuate, giving rise to drawdowns. In other words, we are almost certain that there will be drawdowns on a regular basis.
Preparing the mind for inevitable drawdowns
As an investor in the stock market, your portfolio will be underwater most of the time, so you are likely to spend a lot of time second-guessing yourself about your trading decisions — should’ve closed the trade, shouldn’t have bought at this time, and similar mental battles.
To succeed in the stock market, you must develop the mental muscle to handle drawdowns!
Drawdowns are inevitable
Because they are inevitable, you need to be prepared. If you are a long-term investor, you get the chance to buy at lower prices (which normally is a gift). If you are a short-term trader, both long and short tend to perform better. Please read our article about stock market crash strategy.