Dealing with Drawdowns

Even the best of investors in the best stocks during the strongest bull markets will at some point face pullbacks and need to deal with drawdowns. I’ve recently experienced this in my own trading in general and a position in Salesforce (CRM) in particular. 

So when I came across this article on the topic it peaked my interest. It’s a good reminder to separate short term trading from long term investing.

Essentially it points out how all of the best performing stocks over the past two decades have experienced large, sometimes near death, declines in their share price before roaring back.

This includes Apple (AAPL) Amazon (AMZN), Microsoft (MSFT) and Alphabet (GOOGL), all among the largest and most revered companies in the world. All have returned unfathomable amounts to their shareholders. All have experienced periods of tremendous adversity with large drawdowns.

When it comes to big winners in the stock market, adversity and large drawdowns probably aren’t the first words that comes to mind. We tend to put the final outcome (big long-term gains) on a pedestal and ignore the grit and moxie required to achieve that outcome.

But moxie is the key to long-term investing success, for there is no such thing as a big long-term winner without enduring a big drawdown along the way…

Apple has gained 25,217% since its IPO in 1980, an annualized return of 17%. Incredible gains, but these are just numbers, masking the immense pain one would have endured over time. Apple investors from the IPO would experience two separate 82% drawdowns, one from 1991 to 1997 and another from 2000 to 2003.But here is some of loops you would have had to hang on through.

AAPL Drawdown 8.19.16 

Amazon has gained 38,882% from its IPO in 1997, an annualized return of over 36%. To put that in perspective, a $100,000 investment in 1997 would be worth just under $39 million today.

Breathtaking gains, but they were not realized without significant adversity. In December 1999, the initial $100,000 investment would have grown to $5.4 million. By September 2001, less than 2 years later, this $5.4 million would shrink down to $304,000, a 94% drawdown. It took over 8 years, October 2009, for Amazon to finally recover from this drawdown to move to new highs.

AMZN drawdowns 8.18.16

The below numbers in CRM has me reconsidering whether I should bail out now on the current weakness.

CRM Drawdown 8.16.16

As these examples show large drawdowns are an inevitable part of achieving high returns. If you haven’t yet experienced such a gut-wrenching decline, then you probably haven’t owned something that has appreciated 10x, 20x or more. Or you simply haven’t been investing for that long.

As Charles Bilello goes on to write in the article, “I know what you’re thinking. There has to be a better way. You want that big juicy return but without the big drawdown. Yes indeed, as does everyone else.

The problem, of course, is in trying to hedge or time your exposure to big winners, you will likely miss out on a substantial portion of the gains. Or your emotions will cause you to sell at precisely the worst time (after a large drawdown). Your volatility and drawdown profile may be lower, but that tradeoff will come at a price. As I wrote earlier this year the price for hedge fund investors seeking lower volatility/drawdown in equities has not been a small one, with the HFRX Equity Hedge Index (an investable index of Long/Short equity funds) posting a negative return since 2005 while the S&P 500 has more than doubled.

Many investors in these funds were seeking the Holy Grail, a high return (often 15-20% in their “mandates”) with little risk (no large drawdowns). They expected their managers to pick the Apples and Amazons of the investment world without incurring the inherent volatility that comes along with it. As we know, that is a complete and utter fantasy.

All big winners have big drawdowns. Accepting this fact can go a long way toward controlling your emotions during periods of adversity and becoming a better investor.

— Steve Smith

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About the Author: Steve Smith