When it comes to investing, risk is often overlooked. Investors tend to focus on total return without taking into consideration the amount of risk taken to generate that return.
Measuring Risk
There are many ways for investors to measure risk. However, the primary measure of risk focused on here is maximum drawdown. This term may be unfamiliar, as it is not widely used in the financial media, but is an excellent way to measure risk in the real world.
Maximum drawdown is the magnitude of decline from an investment’s highest value to its lowest value during a given period. Over time, this becomes the pain factor when investments decline in bear markets. No matter what the long term results of any investment is, you must be able to tolerate the maximum drawdown to consider it a suitable investment choice for your risk level.
This chart is for illustrative purposes only and must not be relied upon to make investment decisions.
What is Tactical Investing?
Unlike a buy and hold strategy, tactical investing is intended to actively adjust the portfolio allocation based on a changing market environment. While there are different approaches to tactical portfolio management, from our point of view, we subscribe to the unconstrained tactical philosophy. We can invest anywhere and, in any combination, (i.e., stocks, bonds, cash, commodities, alternatives) at any time as guided by our composite of investment indicators.
With tactical investing, the objective is to position your assets for growth during bull markets and help protect them in bear markets. Still, it’s important to note that tactical investing is not intended to perfectly time the market bottoms or tops (that would be magical if it was).
We like to think that maximum drawdown and tactical investing are in concert with each other but have different deliverability—the maximum drawdown is what we look at from a risk-evaluation perspective, while tactical investing is how we actually do it.
Do you know the Maximum Drawdown of some
of the largest funds in the industry?
Fund Name*
American Funds Growth Fund of America AGTHX
Dodge and Cox Fund DODGX
Fidelity Contrafund FCNTX
Vanguard 500 Index Investor VFINX
Maximum Drawdown (Daily as of 12/31/23)
-51.91%
-63.21%
-49.21%
-55.26%
Fund Examples* (Daily as of 12/31/23)
American Funds Growth Fund of America AGTHX
Maximum Drawdown -51.91%
Dodge and Cox Fund DODGX
Maximum Drawdown -63.21%
Fidelity Contrafund FCNTX
Maximum Drawdown -49.21%
Vanguard 500 Index Investor VFINX
Maximum Drawdown -55.26%
>> If you are not comfortable taking on this amount of downside PAIN then it’s time to reassess your risk profile and holdings.
Mathematics of Advances and Declines
One of the major tenets of risk management is the importance of avoiding catastrophic losses. All investments incur losses at some point in time, but it is extremely important to keep losses recoverable. Beside the simple fact that downside risk management is the key to long-term investing success, it also allows for peace of mind.
Let’s look at a simplified example that examines the mathematics of advances and declines:
Year(s)
1
2
3
Annualized
Investment A
22.00%
8.00%
-7.00%
7.01%
Investment B
35.00%
18.00%
-30.00%
3.70%
Investments
Year 1
Investment A | 22.00%
Investment B | 35.00%
Year 2
Investment A | 8.00%
Investment B | 18.00%
Year 3
Investment A | -7.00%
Investment B | -30.00%
Annualized
Investment A | 7.01%
Investment B | 3.70%
Most investors would select Investment B based solely on the large gain in Year 1. However, if you annualize those numbers the importance of avoiding catastrophic losses becomes very apparent.
The reason behind this outcome comes down to simple mathematics that most investors ignore:
Let’s say you start with $100,000 and lose 50%. That account is now at $50,000, and in order to get back to your original investment you would need a 100% return. Conversely, if your account declined 10% it would be at $90,000 and in order to get back to your original investment you would only need a gain of 11.1%.
Potomac works with Advisors every day to help their clients avoid these scenarios. Learn more about “Why Advisors Need an OCIO.”
Our mission, “Built to Conquer Risk™,” is more than a slogan. We aim to sidestep major market losses (the catastrophic ones, remember 2008?). Our investment approach places odds in favor of success through being flexible with portfolio allocations and trading based on time-tested, quantitative model of indicators, and we use cash as a “risk-off” position, as it can be a useful investment vehicle.
Connect with our Sales Team about how Potomac strategies are Built to Conquer Risk™
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DISCLOSURES
*Data from Ycharts using funds with an inception date greater than 10 years.
This information is prepared for general information only and should not be considered as individual investment advice nor as a solicitation to buy or offer to sell any securities. This material does not constitute any representation as to the suitability or appropriateness of any investment advisory program or security. Please visit our FULL DISCLOSURE page.
IMPORTANT DEFINITIONS USED IN THIS REPORT
Drawdown: A Drawdown is any losing period during an investment record. It is defined as the percent retrenchment from an equity peak to an equity valley. A Drawdown is in effect from the time an equity retrenchment begins until a new equity high is reached.
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