Avoiding Drawdown - In Trading & Investing

Thanks for the visit. Today we look at the importance of limiting drawdown in trading. If you find value, please hit the like button and consider subscribing. A drawdown is simply a decline in your trading account from its highest point to its lowest point. The decline is often caused through a higher volume of losing trades in ratio to winning trades, or larger sized losses in ratio to the size of winning trades, or a combination of both. In trading terms, the size of a loss or a win is often referred to as the risk and reward ratio. The occurrence of each outcome provides what is referred to as the win rate. If either of these metrics are negatively out of proportion, a drawdown is often the result. The essence of good trading or investing is making more than the market averages in good market conditions and losing less than the market averages in bad market conditions. If you can do this for long periods, you will end up ahead of the game. Drawdowns are, however, inevitable. Every trader experiences them and although limiting drawdown is quite a simple concept, it is very difficult to implement for most traders. One prominent reason is the urge to be in the market all the time. If traders simply sat tight on cash during downtrends or choppy markets, they would do much better. Members who follow my approach will know I am an advocate of the MACD indicator and in this example of the S&P 500 index, we can see how a simple rule can keep us from drawing down our account significantly. During the pandemic of 2020, the index dropped by 35%. However, if the trader moved to cash after the MACD indicator turned negative and only re-entered when it turned positive, the drawdown would have been eliminated and the overall performance would have been significantly better. A similar technique could have been used during the financial crisis of 2008, albeit during a more volatile and prolonged period. By leaving the market on a MACD cross down, we would have largely escaped the major losses. Or perhaps the weekly MACD suits your style better, in which case you would have remained in cash for longer periods and likely turned a disastrous year into a profit. My approach is similar, although I use the MACD on individual stocks rather than the index itself. The point today, however, is not to look at the numerous indicators available to prevent us from drawdown, but to demonstrate how limiting drawdown can have such a significant impact. Let's consider two scenarios. Trader A and the more experienced Trader B. Both start with an equity balance of $10,000. Both traders achieve the same return of 100% in years 1 and 3. However, during market downturns across the globe, years 2 and 4 saw both traders make a loss. Trader A made a loss of 40% in each year, and although Trader B also made a loss, he managed to limit them to 15% in each of those years. The overall profit for Trader A was $4,400, which equated to a 44% return. The overall profit for Trader B was $18,900, which resulted in a significantly higher 189% return. Even though both traders made the same amount on the winning years, it was the size of the drawdown during losing years which had the biggest impact. The drawdown differences totaled 50%, whereas the overall performance difference between both traders equated to 145%. This simplistic example can be better seen and exaggerated over a longer period when the effects of compounding are more obvious. Here we use the Eurostoxx 50 index over a 10-year period from the beginning of 2007. Once again, we have Trader A who remains fully invested throughout the 10-year period, whereas Trader B avoided two significant drawdowns by moving into cash. The performance difference in this example is far more considerable. Investor A lost 15% over the 10-year period, whereas Investor B returned a profit of 229%. There are two primary factors impacting this outcome. One, the principle of compounding interest, and two, the percentage illusion phenomenon. Any loss in capital deprives the compounding effect from the reinvesting of profits, also meaning any future growth will start from a lower base, which is perhaps obvious to most. The percentage illusion, however, is a little harder to digest. Let us take a look at this highly important phenomenon. Many people believe that two identical absolute values, negative or positive, have the same impact on an investment. For example, most believe that a 10% loss would require a 10% gain to recoup the loss, when in fact an 11% gain would be needed to get back to even. The demands on recovery become even more pronounced when the loss is allowed to grow further. A 5% loss and a 5% gain is just about enough to get back to even. A 10% loss requires an 11% gain, and a 20% loss requires a 25% gain to recover. However, this is where the percentages really start to get exaggerated. A 50% loss requires a 100% gain, and an 80% loss requires a 400% gain just to get back to even. Therefore, it is so important to keep losses limited. If not, they will work exponentially against us, and the bigger the loss, the harder the recovery. But how do we avoid drawdowns? The answer is we can't, with any guarantee. We can only control them. There are so many variables to provide a definitive answer regarding the control of a drawdown. We could use the moving averages, the MACD, or the relative strength indicators, chart patterns, or perhaps a set percentage against an index. The key is to have something. My personal mechanism is built into the system I teach. For example, I'm a breakout trader, and when the overall market is performing well, I have numerous qualifying trades breaking out of consolidation. When the market is heavily declining, many of my trades are closed due to the parameters I set within each individual trade. Additionally, there are far fewer, if any, qualifying positions to consider during a decline. Therefore, by default of the system, I hold a higher percentage of cash the more the overall market declines. This cycle continues, the market recovers, I have more opportunities, and less cash on the sidelines. But again, there is no guarantee of avoiding every decline, although there must be some form of control. Remember, the more we stay invested here, the harder it is to recover. If this was a 50% decline, we would need a 100% gain to recover. If we managed to limit the drawdown to 20%, we would only need 25% to recover. There is, of course, a flip side to limiting losses and drawdown. We don't want our rules or stop-loss positions to be so tight that we choke the profit out of our trades. In simple terms, we want to get from A to B without drawing down too much, and it's okay to see a margin of decline en route. But anything more and the recovery percentages start to work against us, and we lose the benefits of compounding, not to mention the psychological impacts. Other than the many technical indicators used to limit losses, we can also look at diversifying across sectors and asset classes, or even looking at shorting the index to act as a hedge against major drawdown. Whichever approach you take, just make sure you have a drawdown plan. If you don't, you face an uphill task. Thanks for watching, and as always, why not consider subscribing or even joining our group? See you soon.