One of the key aspects of portfolio management is taking care of risk. Accepting that drawdowns are a necessary evil is always an important realisation. Nobody likes to have drawdowns, but they’re an unavoidable part of the investment game.
For those unfamiliar with the concept, a “drawdown” is the decline of a portfolio from its peak. If, for example, reaches Sh100,000 and then pulls back to Sh80,000, it has experienced a 20 per cent drawdown (loss).
So, why is it important to avoid investment losses? Why is it important for investors to determine their maximum drawdown before investing? Here are my best-two reasons.
One, usually the recovery of money lost often takes a long time because of the massive gains required to break even. If one loses five per cent of their portfolio, it will take only a 5.3 per cent gain to breakeven but if the loses are 50 per cent of the portfolio, it will take a 100 per cent gain to break even. The reality of break-even loss analysis (see the breakeven chart) makes losing 50 per cent of the portfolio intolerable.
After losing 50 per cent, if the market gains 10 per cent per year, and one remains 100 per cent invested, it would take seven years (seven instead of 10 because of compounding) to break even.
What’s worse, in the real world, the recovery time could take much longer since markets rarely move in straight lines.
Case in point is investors who lost 35 per cent in 2008 and have remained 100 per cent invested in equities, are yet to breakeven because their recovery has suffered two losing years since then (2009, -7.8 per cent and 2011, -27.7 per cent).
Two and last, portfolio losses hinder the investor from participating in future investment opportunities. This is because money lost is capital that is no longer available for investment.
If an investor were to lose 40 per cent of their portfolio this year, they would only remain with 60 per cent of their capital available to hunt for any potential investment.
Now, if the investor had a pre-determined 20 per cent maximum portfolio loss, they would have at least retained an extra 20 per cent of their funds ready for investment in the next up cycle.
The lesson: a well-planned asset allocation should allow an investor to be more aggressive when price trends are weak and more conservative when price trends are strong. In other words, investors ought to develop drawdown-alert asset allocations plans that control their investment losses.
As surely as the sun rises, losses will always be part of investing. Over the past 20 years, the market has experienced a total of 10 losing years.
This is the reason why investors need to be pro-active in preserving capital. Unfortunately, this is where most investors mess up — they pay too little attention to investment risk.
Investors who do not appreciate the importance of risk management in their investing plan get washed-out eventually.
In all, investors need to remember that portfolio management is as much about controlling losses as it is about making money. Anyone can make money in rising markets. But the true test of a good investor is avoiding large drawdowns in bear markets.
Mr Mwanyasi is the founder and managing director of Canaan Capital Limited. Email: firstname.lastname@example.org