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The Inevitable Slump: A Guide to Dealing with Drawdowns
Dealing with Portfolio Drawdowns
There’s nothing more debilitating for a market participant than a deep portfolio drawdown. Though investors are almost always in drawdowns (defined as their account balance being below all-time highs), some can be worse than others. Stop losses and stocks that go in the wrong direction are part of the game of investing, but how investors deal with these losses determines their success. Often, a deep drawdown can be a self-fulfilling prophecy. For some investors, the sight of their P&L dropping can cause fear. For other investors, a deep drawdown can lead to knee-jerk decisions in a desperate attempt to make back lost money.
Below are some steps that I have learned that have helped me deal with drawdowns in my own investing journey:
· Stop Digging a Hole: As Warren Buffett warns, “If you find yourself in a hole, stop digging.” The last thing you want to do is make things worse, decrease exposure. Suppose an investor decreases their position size to a quarter or fifth of the normal size. In that case, it will help to limit further losses and alleviate the psychological doom loop associated with drawdowns.
· Focus on Getting Your Bat on the Ball: Concentrate on the highest probability trades, scaling up your position size only as trades begin to work in your favor.
· Conduct an Analysis of your Strategy and the Market: The best investors look inward during drawdowns. Ask yourself, “Is my strategy faulty?” If you find that your strategy is sound, it may simply be a case of you trying to force trades in an unfriendly market environment. Remember, no strategy is bullet-proof in all market environments.
Portfolio Drawdowns and Recoveries
After you’ve clawed your portfolio out of a deep drawdown, you must remember the psychological and monetary pain you endured so that it does not happen again and acts as a valuable lesson in the future. Below are some mathematical facts about the asymmetry of drawdowns that will help you to understand how painful deep drawdowns can be:
· A 25% portfolio drawdown requires a 33% gain to break even.
· A 50% portfolio drawdown requires a 100% gain to break even.
· A 75% portfolio drawdown requires a 300% gain to break even.
· A 90% portfolio drawdown requires a 900% gain to break even.
Though there is no risk without reward, the above numbers show just how devastating large drawdowns can be for investors. Instead of focusing on potential returns, investors prioritize risk management.
Drawdowns: Other considerations to Consider
Position size is typically the main culprit of large drawdowns. A friend of mine once said, “If you find yourself feeling like you just won or lost the Superbowl, you’re likely trading too large.” In addition, oversized positions can exacerbate losses in hyper-volatile spec stocks like OpenDoor ((OPEN - Free Report) ),Strategy ((MSTR - Free Report) ), or BitMine Immersion ((BMNR - Free Report) ). Instead, I have found it much more optimal to focus on liquid, institutional quality stocks like Alphabet ((GOOGL - Free Report) ) or Apple ((AAPL - Free Report) ). These stocks are less volatile, more predictable, and trade smoother.
Bottom Line
Deep portfolio drawdowns can be a harrowing experience for investors. How an investor handles these situations determines the difference between success and failure. If you follow the rules from this article, you will emerge from these challenging periods more disciplined and resilient.
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The Inevitable Slump: A Guide to Dealing with Drawdowns
Dealing with Portfolio Drawdowns
There’s nothing more debilitating for a market participant than a deep portfolio drawdown. Though investors are almost always in drawdowns (defined as their account balance being below all-time highs), some can be worse than others. Stop losses and stocks that go in the wrong direction are part of the game of investing, but how investors deal with these losses determines their success. Often, a deep drawdown can be a self-fulfilling prophecy. For some investors, the sight of their P&L dropping can cause fear. For other investors, a deep drawdown can lead to knee-jerk decisions in a desperate attempt to make back lost money.
Below are some steps that I have learned that have helped me deal with drawdowns in my own investing journey:
· Stop Digging a Hole: As Warren Buffett warns, “If you find yourself in a hole, stop digging.” The last thing you want to do is make things worse, decrease exposure. Suppose an investor decreases their position size to a quarter or fifth of the normal size. In that case, it will help to limit further losses and alleviate the psychological doom loop associated with drawdowns.
· Focus on Getting Your Bat on the Ball: Concentrate on the highest probability trades, scaling up your position size only as trades begin to work in your favor.
· Conduct an Analysis of your Strategy and the Market: The best investors look inward during drawdowns. Ask yourself, “Is my strategy faulty?” If you find that your strategy is sound, it may simply be a case of you trying to force trades in an unfriendly market environment. Remember, no strategy is bullet-proof in all market environments.
Portfolio Drawdowns and Recoveries
After you’ve clawed your portfolio out of a deep drawdown, you must remember the psychological and monetary pain you endured so that it does not happen again and acts as a valuable lesson in the future. Below are some mathematical facts about the asymmetry of drawdowns that will help you to understand how painful deep drawdowns can be:
· A 25% portfolio drawdown requires a 33% gain to break even.
· A 50% portfolio drawdown requires a 100% gain to break even.
· A 75% portfolio drawdown requires a 300% gain to break even.
· A 90% portfolio drawdown requires a 900% gain to break even.
Though there is no risk without reward, the above numbers show just how devastating large drawdowns can be for investors. Instead of focusing on potential returns, investors prioritize risk management.
Drawdowns: Other considerations to Consider
Position size is typically the main culprit of large drawdowns. A friend of mine once said, “If you find yourself feeling like you just won or lost the Superbowl, you’re likely trading too large.” In addition, oversized positions can exacerbate losses in hyper-volatile spec stocks like OpenDoor ((OPEN - Free Report) ), Strategy ((MSTR - Free Report) ), or BitMine Immersion ((BMNR - Free Report) ). Instead, I have found it much more optimal to focus on liquid, institutional quality stocks like Alphabet ((GOOGL - Free Report) ) or Apple ((AAPL - Free Report) ). These stocks are less volatile, more predictable, and trade smoother.
Bottom Line
Deep portfolio drawdowns can be a harrowing experience for investors. How an investor handles these situations determines the difference between success and failure. If you follow the rules from this article, you will emerge from these challenging periods more disciplined and resilient.