These Are The 20 Best-Performing Stocks Of The Past Decade Investing: The Best Way to Win Is By Not Losing A Lot – The Concept of Drawdown

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Investing: The Best Way to Win Is By Not Losing A Lot – The Concept of Drawdown

“Our fund is at the top of its Leaper category.” “Our fund has five stars from Morningstar.” “Our fund has returned X% in the last year (or 3 years or 5 years)” How many times have you heard such claims/statements from investment companies, mutual funds or insurance companies about their funds or sub-accounts? I guess a lot. But did you know that the market represented by the S&P 500 index spent a whopping 82.95% of the time between 1927 and 2012 entering or exiting a significant market decline?

I would like to introduce you to the concept of “drawdown”. Drawdown can be summarized as the gap between the absolute top or peak of an investment’s (or market’s or sector’s) performance and its bottom or trough. During the recent market downturn of 2007-2009, the very popular large-cap mutual fund fell -52% from its peak in May 2007 to its absolute bottom in late February 2009.

Now, to further expand the concept of a drawdown, we are going to look at the period of time it takes to break out of the bottom to be included in a drawdown period. Makes sense, don’t you think? Until you’re back to where you were, you can’t say you’re back on track to meet your pre-recession retirement goals, right? Therefore, the fund manager has to recover the ground he has lost before he can make a real profit. Unfortunately, this is not something that is clearly expressed by investment companies or “star ratings”, nor is it required.

Now to explain the last part of the drawdown concept, how long it takes to recover to the previous high is not clear. In fact, the amount increases in proportion to the loss. That is, the more you lose, the more you need to gain just to get back to where you were. For example, if you lose 10%, say, you need to gain 11% to get back to where you were, and then be positive from there. On the upside, a 20% loss requires a 25% gain to break even. Still not bad, but not moving in a good direction. A 20% loss is sort of the “line in the sand” as far as a reasonable return is concerned. To move to a 30% loss would require grinding through a 43% gain, 5 times the oft-repeated average gain of 8% for large-cap stocks. Finally, our large-cap mutual manager in the second paragraph, with his/her losses of 52%, would need just over 100% to get back on track. So, going back to the examples at the beginning of this article, a particular investment or mutual fund manager could very well earn X% AND have a top-tier Lipper rating AND/OR a 4 or 5 star Morningstar rating, BUT it ALL might not return to “zero point”. Again, chances are you won’t be told this.

What can you bear (no, this is not to depress you)? This is to get you to take an active role in managing your hard-earned money. Ask questions. What makes a manager buy? Why would a manager sell? What does he/she do when his/her market sector falls on hard times? When will he/she buy out at the bottom of the market if they had the foresight to get out in time? (Knowing when to buy and sell is essential to success.) If you’re paying extra for active management, these are things you should know.

While most theme park roller coasters go uphill to return to the drop off/pick up location, there is no guarantee that your “retirement roller coaster” will. You and/or whoever manages your money needs to have a strategy with well-defined entry/exit points and parameters along the way.

Good luck and have a happy day.

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