Maximum Drawdown And Allocation Approaches

  • Simple Buy & Hold, Strategic Fixed Risk Level Allocation, Strategic Flexible Risk Level Allocation, Dynamic Tactical Risk Level Allocation.
  • 4.5 to 10.5 years time to recover to breakeven associated with 6 example Bears.
  • Our view of suitable allocation within Flexible Strategy.

There are many types of risk when investing. Here are 10 of them:

Credit risk
Interest rate risk
Inflation (real return) risk
Currency risk
Tax risk
  Active management risk
Valuation and forecasting error risk
Volatility risk
Maximum drawdown risk
Portfolio longevity in retirement risk

Each of these deserves attention in portfolio construction. In this letter, we examine Maximum Drawdown Risk, which is probably the greatest risk portfolios face over the next couple of years.

Maximum Drawdowns occur infrequently but massively, and it typically takes years to breakeven with the pre-crash portfolio value. In the battle of philosophies between Buy & Hold and Tactical Trend Following, the long recovery time after a Maximum Drawdown is the trend follower’s main argument. We are in the Tactical Trend Following camp for long-term trend reversals. We prefer to take cover in falling markets, by tilting away from equities toward bonds or cash.

Since 1936, US large-cap Bear markets have taken mostly 4 to 6 years from the pre-crash peak to the bottom and back to a breakeven level. Total return recovery from the 2000 Bear took 6.15 years, and from the 2007 Bear it took 4.5 years. Of course, a portfolio diversified with debt assets, experienced a less extensive drawdown and a total return recovery over a shorter period.

This table shows how long it would take for total return breakeven after various levels of portfolio decline, assuming various post-drawdown rates of return:

(click images to enlarge)

Many of us, don’t have the luxury of waiting 4 to 6 years to breakeven with pre-crash levels, particularly if we are making regular withdrawals from our portfolios to support lifestyle.

A young person with only a small portion of future accumulations achieved, engaging in regular periodic investments, cannot only ignore most Bear markets, but actually enjoy buying more shares each month at a lower price during a Bear – maybe even increasing the rate of investment during a Bear.

However, for someone, regardless of age, who has completed the process of adding new money to the portfolio, and is relying on the portfolio for sustenance, the Bear presents a threat, not an opportunity. Of course, if that person has such a large asset base that withdrawals are less than the investment income (interest and dividends), for that person the Bear is more an annoyance than a threat and may present some attractive asset substitution opportunities.

But for most of you, and for me, the Bear is more of a threat than an opportunity if we lean into it and take it in the face full force.

Those are the reasons that generic advice to someone starting out is to put all assets in stocks, to maximize regular monthly savings, and damn the torpedoes in a Bear market. And, those are the reasons as we achieve more and more of our ultimate accumulation (Financial Capital), and the present value of our future earnings from work (Human Capital) declines, and the number of years we have before beginning to withdraw assets decreases (Time Horizon), that we need to diversify our risk (specifically the correlation of return of the assets we own), to mitigate the damage that a stocks Bear market can have on the ability of our portfolio to support our lifestyle now or in the future (to avoid the Risk of Ruin – outliving our assets – to protect Portfolio Longevity).

Unfortunately, diversification is a bit like insurance. It has a cost, at least it seems that way almost all the time, except in the instance that you need it. You lament the premium you pay for your auto, home or medical insurance, until you have a major claim event. Then you are so glad you had the insurance. Same thing with portfolio risk diversification (diversified asset return correlation), which is predominantly accomplished with high-quality debt assets (particularly Treasuries). High-quality debt assets do not generate returns over short periods as high as equities do, but they do not experience Maximum Drawdowns as severe as stocks – thus moderating overall portfolio Maximum Drawdown. This picture tells the story:

From the early 1990’s (close to 30 years) the S&P 500 generated a cumulative return over 950%, while the Aggregate Bond market generated a cumulative return of only 265% — and a balanced portfolio of 60% S&P 500 and 40% Aggregate bonds generated a cumulative total return of 630%.

Who would want 265% when they could have 950%? My grandchildren certainly should look to the 950%. But most of you can’t safely deal with Maximum Drawdowns that are likely over 30 years.

Here is how the aggregate bond index helped in the last two Bears (beginning in 2000 and 2007):



The 2000 Bear and the 2007 Bear were back-to-back in a sense because the October 2007 pre-crash peak was only one year after the S&P 500 reached total return breakeven in October 2006 after the 2000 crash.

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Danny Straus 1 year ago Member's comment

A new concept for me, thanks.