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Diminish Dreaded Drawdowns

| May 03, 2020

Executive Summary

Some people are already independently wealthy aka do not have to work to generate enough purchasing power cash flow for living expenses. When one has worked for a number of years and has accumulated enough to generate cash flow for living expenses for their lifetime(s,) we might call them securely retired. Or, at least they might feel that way.

When cash flow for needs can be generated entirely from guaranteed ... or perhaps very secure, conservative sources ... e.g. pension, Social Security, US Treasuries etc., .... we might agree they have (or will be able to) retire securely.

On the other hand, if some of the purchasing power cash flow for need expenses (e.g. food, shelter, taxes, medical etc.) is planned to be derived from assets whose value and therefore cash flow fluctuate (e.g. the stock market,) then that retirement is less secure. Because stocks can go down as well as up. The Dreaded Drawdown.

Primary Audience for this post:

  1. Within 5 years of retirement or closer or already retired.
  2. Need at least some income from retirement nest egg to maintain standard of living during retirement
  3. Protection .... then Income are crucial for this audience.

"Drawdown:" Definition + key points

  1. "A drawdown refers to how much an investment or trading account is down from the peak before it recovers back to the peak.
  2. Drawdowns are typically quoted as a percentage, but dollar terms may also be used if applicable for a specific trader.
  3. Drawdowns are a measure of downside volatility.
  4. The time it takes to recover a drawdown should also be considered when assessing drawdowns.
  5. A drawdown and loss aren't necessarily the same thing. Most traders view a drawdown as a peak-to-trough metric, while losses typically refer to the purchase price relative to the current or exit price."
Source:  Investopedia

Bruce Comment:

The most recent drop, (we really don't know yet if it was a true drawdown, because we could have another leg down)  was the fastest ever. Does that mean it will be fastest to come back. I don't know.  But the really troublesome historical factoid is the chart below showing Sept 1929 to Nov 1954. If you are, for example, age 66 now, you need to analyze and do some meaningful financial planning, to figure out what you might do if the drawdown doesn't get back to where it was for 25 years! YIKES! :-( 

FROM: Of Dollars and Data

"As of 3/23/2020, the Dow Jones is 35% off its highs, in what has been one of the worst months in U.S. stock market history.  

If we analyze every decline greater than 30% back to 1915, you can see that our current crash is one of the fastest ever:"

"More importantly though, while all the crashes prior to today have their respective bottoms marked with red, we have no clue whether we are anywhere near the bottom for the coronavirus crash."    Source: Of Dollars and Data

Concentration Risk

Part of the reason why index funds don’t offer good risk management is that they tend to gravitate toward a narrow set of high-performing, in-the-moment stocks.

As more money flows to all the same stocks, their prices go even higher, and they become more and more overvalued. In the case of the S&P 500, it’s a capitalization weighted index; that means that money invested in a given index fund does not get evenly distributed across all 500 stocks. The five largest S&P 500 stocks have a market capitalization equal to the bottom 282 stocks!

Source: Potomac


Source: Potomac

Why is this important? The Arithmetic of Drawdowns

AKA - also known as - What ROR - Rate of Return - is needed to get back to where I was?

Breakeven Chart

Source: Potomac

Conclusion: Range of Possible Outcomes

  1. Two of my college roommates are MDs as well as two brothers-in-law and others I know well.
  2. Medical professionals ultimately often must make very difficult judgments and decisions.
  3. But these judgments - decisions - Professional Opinions - are based on facts - data.
  4. And these judgments arise from rigorous academic and practical training as well as, over time, actual experience.
  5. My finance professor William Sharpe at the Stanford GSB - Graduate School of Business - has called retirement the Nastiest Hardest Problem
  6. Because there are so many moving parts for many retirees
  7. And the future is at least partially unknown and unknowable, i.e.
  8. "Past performance is not a guarantee of future results."
  9. Arm yourself with available facts.
  10. Carefully consider YOUR Range of Possible Outcomes
  11. Consider a professional second opinion

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