Losing something of value is troublesome.
Whether it's a set of car keys, a pair of sunglasses,
or money in a portfolio, a loss can weigh you down
and affect your judgment.
Losing money is particularly worrisome.
Investors often refer to losing money as a drawdown.
This is when an investment account has less than before.
Sometimes an unexpected loss can lead to poor decision making.
Greed can take hold and prompt an investor
to take excessive risks in an attempt
to recover what was lost.
Excessive risk taking usually leads to bigger losses,
and sometimes, disaster.
This chain of events from small loss to financial disaster
occurs all too often in the markets.
In the investing world this cycle
is known as the drawdown effect, and it's a danger
for all types of investors.
The drawdown effect starts with a routine drawdown,
or small loss, in an investor's portfolio.
Instead of figuring out how to recover the lost money,
the investor lets this small loss consume every thought
and impact judgment.
This mindset leads the investor to abandon risk management
and pursue an all or nothing approach.
Then the investor gives up on the idea of limiting losses
and forgets that the reason for limiting losses
in the first place is to make recovery quicker and relatively
easier.
Investors experiencing a drawdown effect
forget that increasingly large losses
require exponentially higher returns for recovery.
A drawdown of 10%, for example, requires a return of about 11%
for recovery.
A loss of capital and the required recover return
are not one-to-one.
That's because the initial loss results
in a lower starting point from which recovery begins.
It works like this.
Suppose an investor starts with an account worth $100,000.
A loss of 10% takes the value of the account down to $90,000.
This is the new base from which recovery begins.
It's a lower base to start with, requiring a higher
return than is equal to the initial loss.
A return of 10%, the same size as the initial loss,
only gets the account back to $99,000.
A return of a little over 11%, however,
will bring the account back to its starting point of $100,000.
Now let's look at a larger drawdown, say a loss of 50%.
Recovery from this loss requires a 100% return.
That's a big return that might take a very long time
to achieve.
Investors lose sight of these recovery dynamics
when the drawdown effect takes hold.
The loss suffered by the drawdown effect
can be compounded by underestimating the total risk
across a portfolio.
This risk is known as portfolio heat.
It's the total loss, or worst-case scenario,
if all open positions in a portfolio
hit their stop losses simultaneously.
For example, suppose an investor has
five positions in a portfolio.
Each position has a stop loss of 10%.
The portfolio's total value will drop 10%
if all five positions are stopped out simultaneously.
The 10% loss across the entire portfolio
is the worst case scenario, or the portfolio's heat.
To help minimize a portfolio's heat and the drawdown effect,
investors can use three risk management techniques.
The first technique is properly allocating a portfolio
and spreading risk across multiple asset classes.
The second technique is to diversify
among subclasses of assets.
And the third technique is position sizing,
which helps balance risk among individual positions.
It's also important to understand that markets change
over time, and strategies you're using today won't work forever.
If a drawdown lasts longer or is bigger than expected,
consider reevaluating how your investing strategies fit
with the changing market, and adjust them accordingly.
Remember to keep a level head, and don't let greed
dominate your decision making.
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