Portfolio Drawdown

Portfolio Drawdown There are many investors and money managers who regularly take enormous risks, and unacceptable drawdown. The GetFolio Strategy has not only produced consistently high returns, but has done so with remarkably low drawdown. Once you understand the concept of controlling your drawdown, you will be in a better position to manage your money successfully. Learn to control your drawdown, and you will be successful

In the market, when an account goes down in value, it's called a drawdown. Suppose you open an account for $50,000 on August 15th. For a month and a half, the account goes straight up and on September 30th, it closes at a high of $80,000 for a gain of 60%. At this point regardless of your drawdown, you may still be in all of the same trading positions. But as a professional, your account is "marked to the market" at the end of the month and statements go out to your clients indicating what their respective accounts are worth. Now, lets say that your positions start to go down in value around the 6th of October. Eventually, you close them out around the 14th of October and your account is now worth about $60,000. And let's say, for the sake of discussion, that your account at the end of October is worth $60,000. Essentially, you've had a peak-to-trough drawdown (peak = $80,000, trough = $60,000) of $20,000 or 25%. This may have occurred despite the fact that all of your trades were winners. It doesn't really matter as far as clients are concerned. They still believe that you just lost $20,000 (or 25%) of their money. Let's say that you now make some losing trades. Winners and losers, in fact, come and go so that by August 30th of the following year, the account is now worth $52,000. It has never gone above $80,000, the previous peak, so you now have a peak-to-trough drawdown of $28,000 -- or 35%. As far as the industry is concerned, you have an annual rate of return of 4% (i.e., the account is only up by $2,000) and you are now labeled as having 35% peak-to-trough drawdown. And the ironic thing is that most of the drawdown occurred at a time in which you didn't have a losing trade -- you just managed to give back some of your profits. Nevertheless, you are still considered to be a terrible money manager. Money managers typically have to wear the label of the worst peak-to-trough drawdown that they produce for their clients for the rest of their lives. Think about it from the client's viewpoint. You watched $28,000 of your money disappear. To you it's a real loss. You could have asked for your money on the first of October and been $28,000 richer. Trading performance, as a result, typically is best measured by one's reward-to-risk ratio. The reward is usually the compounded annual rate of return. In our example, it was 4% for the first year. The risk is considered to be the peak-to-trough drawdown which in our example was 35%. Thus, this traders reward-to-risk ratio was 4/35 or 0.114 -- a terrible ratio. Typically, you want to see ratios of 2 better in a money manager. For example, if you had put $50,000 in the account and watched it rise to $58,000 you would have an annual rate of return of 16%. Let's say that when your account has reached $53,000, it had drawn down to $52,000 and then gone straight up to $58,000. That means that your peak to trough drawdown was only 0.0189 ($1,000 drawdown divided by the peak equity of $53,000). Thus the reward-to-risk ratio would have been a very respectable 8.5. People would flock to give you money with that kind of ratio. Let's take another viewpoint and assume that the $50,000 account is your own. How would you feel about your performance in the two scenarios? In the first scenario you made $2,000 and gave back $28,000. In the second scenario, you made $7,000 and only gave back $1,000. Let's say that you are not interested in 16% gains. You want 40-50% gains. In the first, scenario you had a 60% gain in a month and a half. You think you can do that several times at year. And you're willing to take the chance of giving all or most of it back in order to do that. You wouldn't make a very good money manager, but you might be able to grow your own account at the fastest possible rate of return if you could "stomach" the draw downs. Both winning scenarios, plus numerous losing scenario, are possible using the same trading system. You could aim for the highest reward to risk ratio. You could aim for the highest return. Or you could be very wild, and lose much of your money by risking too much on any given trade.

URL: http://www.getfolio.com/investment_stocks/drawdown.asp