On Drawdowns...

One of my favourite phrases in the arsenal of financial journalists is "xyz hits all-time high".

It definitely sounds significant, doesn't it? This investment's value is as high as it has ever been!!

But. Investments are expected to go up. In a world of zero volatility, investments should hit all-time highs EVERY. SINGLE. DAY. So perhaps it's not that important.

In a binary view of the world, all investments exist exclusively in two states – all-time high, or drawdown. If an investment drops even 0.01% from a prior high, it’s in drawdown. If it goes above a prior high by 0.01%, it’s at a new high. When you think about it that way, suddenly neither seems that exciting, or noteworthy.

The chart below shows the performance of the S&P 500 over the last 25 years. To be honest I could have picked pretty much any index but I picked the first one that sprung to mind. So, don't go crying "you've cherry picked the data" (at least without checking out the appendix where I’ve put a load of other indices ??).

This chart brings to life the drawdown versus all time high point brilliantly. What's more, the time spent in each "regime" might be surprising too. Based on weekly data, 83% of weekly periods were below previous highs i.e. "in drawdown". The concept of drawdowns sounds scary, but the key message is to get used to them. You're going to spend most of your investment journey NOT at an all-time high.

Source: S&P 500 total return index, weekly data over 25y to October 22, green highlights for all time highs, red for drawdown

Loss aversion refers to an individual's tendency to prefer avoiding losses to acquiring equivalent gains. Research suggests we feel bad about losses almost twice as much as we feel good about gains. Which is pretty important if we’re to spend most of our investment lives technically in “loss” territory.

There is some good news though. Most people probably don’t check their accounts every week. If they checked their account every month (for the same S&P investment) they’d only be in drawdown roughly two thirds of the time. Checking quarterly, 50% of the time. Checking annually, around 35% of the time. Even those numbers could be higher than people might expect – and still feel bad! However, it emphasises that for investments that are long term, less frequent updates may help investors that feel loss aversion stay the course.

All time highs don’t matter. Drawdowns shouldn’t either, even if we’re behaviorally disposed to feel them more. Investors and investment process should be comfortable with them because they are so normal. Away from the statistical observations made here, it’s often in drawdowns (usually those that are material) that the best investment opportunities present themselves.

Matthew Yeates, October 2022

The views in this piece are absolutely my own and absolutely nothing to do with my employer. I fully accept the of risk being hung, drawn and quartered if I don't remind you that all investments have "Capital at risk". Charts/ data are purely for illustration purposes only.

If you have opinions/ thoughts/ questions on this article, please comment/ share or ask questions!

Appendix

This table shows the proportion of weekly periods over the last 25y each index was in drawdown versus a prior all time high. In a couple of cases (EM and Global Aggregate bonds) 25y wasn't quite available so covers periods closer to 23 and 21 years respectively.