Contributed by: Nicholas Boguth
It is imperative to try to avoid major drawdowns when investing. This may seem intuitive, but let’s take a closer look.
Drawdown is a metric used to measure risk. It is a measure of the peak-to-trough decline of an investment or portfolio. Minimizing drawdown is arguably more important than seeking large returns when it comes to investing, and here is why:
Below is a simple chart showing the returns investors would need to get back to where they started if they lost 10%, 30%, and 50%. The math is relatively simple: if you start with $100 and proceed to lose 50%, you now have $50. In order to get back to the $100 that you started with, your $50 would have to gain $50, or increase by 100%.
So the math is simple, but who really cares about the hypothetical? Let’s look at how the S&P 500 actually performed compared to diversified portfolios during the drawdown that started in ’07. The chart below, from JPMorgan’s Guide to the Markets, shows how the S&P 500 lost over 50%, and took 3 FULL YEARS before it recovered back to its peak. Compare that to the 40/60 portfolio. Since the drawdown was significantly less, it was a much quicker recovery and broke even after just 6 months. This is why it is important to try to avoid major drawdowns when investing.
For a more in depth look on drawdowns and sequence of returns, check out the Investor PhD blog written by our Director of Investments, Angela Palacios, CFP®.
Nicholas Boguth is an Investment Research Associate at Center for Financial Planning, Inc.® and an Investment Representative with Raymond James Financial Services.
The information contained in this blog does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Nick Boguth and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results.