When the Drawdown Cometh…

There is an unfortunate truth about trading and investing that you must know:

EVERY strategy will go through bad times at some point.

Good strategies will have bad days.

Good strategies will have bad months.

Good strategies will have bad years.

Ask any trader or investor who has been in the business for a long time. Markets wax and wane. Strategies go through good times and bad. The balance of an account ebbs and flows.

If someone wants to help you invest your money but will not have an open and honest discussion about risk and drawdown – run for the hills from that person.

For US stocks, since the beginning of the second quarter of 2016 until the recent highs put in around the end of January, stocks have enjoyed a smooth and pleasant ride higher. Corrections were shallow and traders who “bought dips” or sold volatility were consistently rewarded.

My how things have changed!

There is an old adage in the trading world – Volatility happens fast – and nothing could be truer with regard to the recent spike in volatility.

On a closing basis, as of Friday, 3/23, the S&P 500 was down about 10% from its 1/26 closing high. And while 10% corrections are fairly common in the world of investing, after seven quarters of easy money, many investors are feeling jittery about their exposure to equities.

And to be honest – so are we!

As the S&P is off its highs, so is the Alpha Momentum Strategy.

To borrow lyrics from one of our favorite bands, Daft Punk, “we are human, after all.” And even though we have extensive experience in markets, we have studied market history, we have a well thought out, well researched, well tested strategy, and we know that our systems will experience trying times, that doesn’t necessarily make it any less difficult to stick with our system in those trying times, like now.

So what can we do to make trying times less difficult?

Simple – gain a little perspective.

In our opinion, this is what makes systematic, or rules based trading like our core strategy, so helpful.

Before we invest a single dollar, we outline our rules. We test those rules across various market cycles. IF, and this is a key point, IF our rules are robust and not curve fit to the data, we see what has happened in the past, and therefore, we can get a sense for how those rules are most likely to respond to future markets.

That is not to say that surprises cannot happen. They absolutely can. But with a robust and well tested system, we can get perspective which can not only help us in our asset allocation decisions (e.g. how much money to invest in any particular strategy or asset class), but which can help us put market conditions in context in real time.

And context in real time helps us stay calm in times of stress. It helps us keep a long term perspective. It helps us not to panic. It helps us stay the course.

So with all that said, lets gain some context.

Currently, the Alpha Momentum Strategy is in drawdown (for more discussion on the topic of drawdown, see our previous article here). The strategy is -8.5% of its last high seen on 1/22, meaning that we have now been in drawdown for about 2 months or about 40 trading days. Note that we are not currently at the low of this drawdown which (at least thus far) was on 2/7 when we closed at a drawdown of -12.5%; so we are off our lows a bit. Let’s see how this compares to previous drawdowns.

*NOTE – Drawdowns can be viewed over different time frames, depending on the data being analyzed. Typically for long term investors, drawdowns are measured based on month end returns. Most people usually look at their monthly account statements rather than their daily statements. People who do look at their statement every day don’t necessarily look at it every hour. We can analyze drawdowns on any time frame really - quarterly, monthly, daily, hourly, even down to the tick if we want to get neurotic about it. Note that the more granular the data, the larger the drawdowns will be.

Since we are trying to put the recent action in context, we will look at daily drawdowns.

Also note that, when analyzing drawdowns in this way, we must define a threshold for drawdowns. We can’t know what constitutes a drawdown unless we have specified a threshold to define the drawdowns! For the purpose of this analysis, we will define a drawdown threshold of -10%.

So let’s look at the data. From 1985 through the end of 2017, the Alpha Momentum Strategy had 66 daily drawdowns of -10% or worse. That’s 33 years of data, meaning that, on average, the system sees a drawdown of -10% or worse about twice per year!

How is that for some context!? This is pretty darn normal for the system!

Let’s look at drawdown length now. Since the drawdown isn’t over, we don’t know how long it will actually last. That said, we are currently about 40 days into this drawdown. The average length of a drawdown that is -10% or worse has been 43 days. So this drawdown, at least thus far - is about average. Given that we are not too close to coming out of drawdown, this will probably end up being a longer than average drawdown. The longest drawdown for the system, occurring in 1993, was 642 trading days. If there are 260 trading days in a year, that is a drawdown lasting almost 2.5 years! How is that for a possibility?! It can happen!

Let’s look at the worst drawdown now. The worst drawdown for the system was 1987 (no surprise there) at -40% on a daily basis. That means that at one point the system would have been 40% off of its highs!


All of a sudden a -10% drawdown doesn’t seem that bad, eh?

This, again, is the beauty of systematic investing. While we do believe the old adage that “your worst drawdown is always the one in front of you,” doing this type of analysis helps us prepare for what could happen and helps us stay the course when things get difficult.

Before we started trading, we understood this risk and SIZED OUR ACCOUNT ACCORDINGLY.

We recognized that we could lose up to 50% (or more) of our money allocated to the system and only invested an amount that we were comfortable with given that risk. This is also why we do not employ leverage (in this context).

We invested in not only this system, but others which have historically been uncorrelated to this system to reduce risk across the portfolio. We prepared ourselves mentally. And we have context – and context will help us stay the course.

Comparison of drawdowns – system vs S&P 500

Some readers may be reading this commentary and thinking something along the lines of “Woah! 40% drawdowns? 2.5 years+ without making money? Why would I ever invest in something that can produce that type of pain?”

Well, if you are invested in an index or mutual fund exposed to US stocks, you probably have more risk in your equity portfolio than we do in the Alpha Momentum Strategy. As we have demonstrated here the Alpha Momentum Strategy has historically been less risky than simple buy and hold strategies. Lets extend that analysis here and talk about drawdowns going back to 1985, but also include return numbers for more even more context.

The numbers speak for themselves – no further context necessary.

More to come.