You learn from your mistakes. This is especially true in trading. Drawdown analysis is considered to be the most important analysis for any trader. Ups and downs are part of a human’s life and same is the case with markets where bull and bear phases are as sure as day and night. It is how you handle the down phases of markets as well as in life is what decides the winners.
Handling a down phase in market not only requires financial skills but also psychological ones. Faith in one’s trading system or investment philosophy separates the winners from losers. A severe downturn can shake the best of traders and investors who end up getting out of the trade at the wrong-time only to see their investment shooting off in their original direction.
So how can one maintain their poise when the world is falling apart? As legendary investor Warren Buffett says in his famous quote- The stock market is a device for transferring money from the impatient to the patient. Patience is one of the most important virtues in investing. But being over patient can be dangerous too. One needs to have an understanding of the changing dynamics.
One way of understanding the pain point, or the point at which one need to worry is to back test the investment or trading strategy and figure out the levels to which the portfolio can go down before rising again. If say, historically markets have corrected 20 percent in a year while the trader’s portfolio has corrected by 30 percent on an average, we then have a level which can be considered as the threshold point or the level which were historically achieved and chances are that the portfolio
is now in the oversold zone and can see some buying.
In trading parlance this threshold point is called drawdown. A drawdown is defined as the peak-to-trough decline during a specific recorded period of an investment, fund or commodity. It is normally represented as the percentage between the peak and the subsequent trough.
Drawdown helps measure the financial risk of the portfolio. It is an important measure of a portfolio or trading strategy and is far better than the traditional measures. Normally an investor measures his portfolio returns or trading performance by measuring the return based on a specific time frame. For example, he would measure his return from the start of the month or start of the year.
However, drawdown measures the performance from the recent high. Let’s consider an example to understand the importance of drawdown. If a portfolio of Rs 10 lakh touches a high of Rs 14 lakh his return would be 40 percent in the traditional way. Now if there is a correction in the market and his portfolio value falls to say Rs 11 lakh his return in the traditional way will be 10 percent (initial investment was Rs 10 lakh and present is Rs 11 lakh). The trader would still be happy since he has generated a positive return of 10 percent as has not lost his capital despite the severe fall.
But in the drawdown method of calculating returns, the portfolio has fallen by 21.4 percent from its peak. Drawdown would be calculated from the high point of Rs 14 lakh to the low point of Rs 11 lakh – a drop of 21.4 percent.
Just like a mountaineer nails his rope on his way to the top in order to protect himself from falling all the way to the bottom, an investor needs to protect his profits. As in the case of the above example, after earning 40 percent and giving away most of the gains is nothing to be proud of. One needs to have protective stop losses on the way down to secure the profits or add on to hedges on the way down.
Traditional way of monitoring your portfolio would not help improve your performance. Monitoring on a drawdown basis helps you improve your performance vis-à-vis other fund managers and portfolios. Thus, when the market starts moving higher one who has taken precaution to protect his profits would have a head start.
A back testing of trading strategies helps to give an idea of the maximum drawdowns that have occurred in the portfolio. This level can then act as the maximum pain point which a trader has to bear. Though it is not necessary that one keeps on booking losses to touch the threshold level, hedging mechanisms can be put in place to shorten the drawdown levels in future.
Learning from your own mistakes is the best form of learning in the markets. It is only by avoiding old mistakes does a trader achieve his goal of financial freedom. The author is Executive Director of Trade Smart Online