Protecting wealth by limiting “drawdowns”

How will your portfolio perform in a market decline? It’s a question that is likely on the minds of many investors given the see-sawing in public equity markets of late. In this post, we explain the concept of “drawdowns” – what they are, the consequences for investors and how to minimize their impact.

What is a portfolio drawdown?

A drawdown can be defined as the decline in value between one market peak and the next valley. It is usually expressed as a percentage from top to bottom and is most valuable as a measure of portfolio risk.

Drawdowns can be measured by three factors: size, duration and frequency, each presenting their own stomach-churning challenges for investors.

History has shown us both short and sharp drawdowns, as well as gradual, pronounced ones. For example, the S&P 500 lost 20%* between October and December of 2018. Because of its intensity, this type of dramatic and rapid decline can feel very uncomfortable, to put it mildly. It can trigger fear and panic selling, which locks in losses.

Contrast this with a slow and subtle drawdown, such as that which occurred between early 2000 and late 2002. The S&P 500 grinded only 5%** lower but over a prolonged and painful 637 days! Frustration and disillusionment are often by-products of these types of drawdowns. There can even be a tendency for investors to stop contributing to savings and investment plans during these lacklustre return periods.

Both examples are part of the normal pattern of market behaviour but they can lead investors to the wrong decisions at precisely the wrong time.

How do drawdowns affect portfolios?

Drawdowns are speedbumps on the journey to wealth creation and protection. They can rarely be predicted or accurately timed and can have material ramifications for investors.

Drawdowns can have significant consequences for investors who are withdrawing money from their portfolio to fund their lifestyle. If income from the portfolio’s underlying investments is sufficient to fund expenses, a drawdown is unlikely to matter. However, most people rely on a combination of capital growth and income to fund their lifestyle. If this process occurs during a market drawdown, investments will be sold and converted to cash and losses realized. The longevity of the portfolio is potentially reduced under this scenario. As an example, a portfolio of $2,000,000 that suffers a 30% drawdown would require a 43% rate of return just to arrive back at $2,000,000. Earning back money that has been lost requires valuable time that would otherwise be used to generate compound returns above the principal invested.

What can investors do to mitigate drawdowns?

Earning more consistent returns reduces the size, frequency and duration of drawdowns, which can greatly improve the longevity of a portfolio – not to mention reduce stress for the investor!

As an example, suppose two investors each with a $2,000,000 portfolio earned an average annual return of 7% over a 25-year period. Over the period, both investors withdrew $80,000 per year to fund lifestyle needs. Investor A constructed a higher volatility portfolio, meaning the ups and downs were more dramatic than Investor B. This characteristic can be measured using a statistic called standard deviation and we will assume Investor A’s portfolio measured 20%† while Investor B was 5%. In this scenario, at the end of 25 years, Investor A has a 27% chance of running out of money, whereas Investor B has virtually no likelihood of outliving their capital‡. Despite earning the same average rate of return, the outcome may be dramatically different for these two investors.

The differing quality of these returns is an important distinction that investors frequently overlook, or are unaware of, through no fault of their own. Advertising by fund companies tends to shine the light on return numbers – rather than the path to those returns. Read our blog post on Investment performance: what the numbers don’t say for more context on understanding returns.

It is definitely our bias at Newport to deliver attractive rates of return with less risk and volatility. We have access to 12 different asset classes for diversification, which we will overweight or underweight depending on our assessment of risk and opportunity. We also favour investments that produce income, so we are less dependent on appreciation of the principal.

Ultimately, having a better understanding of your and your portfolio’s behaviour during a drawdown will be essential to enjoying a better overall investment experience.

Feel free to get in touch to start a conversation on how to minimize the impact of a market drawdown on your portfolio.

* Thomson Reuters
** http://www.capitalspectator.com/ranking-the-current-us-stock-market-drawdown-vs-history/
† Approximately equal to the historical volatility of the S&P 500 in CDN dollar terms
‡ Results assume a normal return distribution and have been calculated based on 5,000 Monte Carlo simulations. Results also assume 2% inflation.