One of the major risks investors face is a portfolio drawdown – a peak-to-trough decline in the value of their investment portfolio over a given period of time. Substantial drawdowns can derail long-term financial plans and make it difficult to recover lost ground. Understanding and managing drawdown risk is important for successful investing.
A drawdown measures the current value of a portfolio against its highest historical value. For example, if a $100,000 portfolio declined to $80,000, that would represent a 20% drawdown. The deeper the drawdown, the more assets are lost and the harder it becomes to recover those losses through future gains. Below is a chart of a drawdown percentage and what return is needed to get back to breakeven.
Every investment experiences volatility and drawdowns over time. However, the extent of drawdowns varies greatly across different asset classes. Generally speaking, more conservative investments like bonds tend to have shallower drawdowns, while more volatile assets like stocks experience deeper drawdowns.
A basic 60/40 balanced portfolio of stocks and bonds exhibited a maximum drawdown of around 35% during the 2008 financial crisis, based on data from Vanguard. An all-stock portfolio would have fared worse, with a maximum drawdown over 50% during that period.
Portfolio drawdowns of 10-20% are relatively common for a diversified stock/bond portfolio. Larger drawdowns of 30%+ tend to occur less frequently but can take a massive toll if they coincide with an investor’s planned retirement date or a period of portfolio withdrawals.
Concentration Risk
While diversification is universally preached in the world of investing, it is not uncommon for investors to have concentration in specific sectors or even individual names. For individuals that receive stock based compensation, they tend to build up a majority of their wealth in one name. While there are stories of early day Microsoft employees becoming billionaires, there are similar stories of employees at Enron that lost all their wealth. The risk of “ruin” is very real for undiversified investors without sound risk management practices.
Reducing the risk of severe drawdowns should be a priority for long-term investors. Strategies may include diversifying across asset classes, using stop-losses or hedging for protection, investing through vehicles that automatically rebalance, and having enough safe assets to avoid withdrawing funds during a downturn.
No investment approach can eliminate drawdowns entirely, but being mindful of this risk and having a plan to manage it can go a long way toward protecting a portfolio from permanent impairment. Drawdowns are an unavoidable part of investing, but their impact can be limited through proper risk management.
Presented by the Financial Planning Committee of Lake Street, an SEC Registered Investment Adviser
The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful. Investing involves risk and you may incur a profit or a loss.
