Large drawdowns are the most difficult time for an investor and trader. They are painful, but unavoidable when investing with the goal of high risk-adjusted returns. Return is based on taking risks and sometimes these risks are bound to materialize as strings of losses. This will happen regularly in a realm where each outcome is largely random, even if probabilities are in fact skewed in our favor.
When leverage is used to boost risk and return beyond market results, it will cause accelerated drawdowns.
If you experience additional losses, that are caused by mistakes, it gets even worse psychologically as well as from the perspective of available equity: losses take disproportionally larger gains to make up for them the larger your drawdown gets.
To keep the gap between theory and practical implementation as small as possible is essential, if we want to reach our goals – it is a continuous battle against our behavioral biases to avoid as many mistakes as possible.
I want to use the opportunity to periodically record the string of events and mistakes leading to a drawdown, as well as the lessons learned, whenever it exceeds 15% to 20% in a short period of time.
It is hard to write about this, when the experience is fresh and the urge is to push the pain away and forget about it. That is also a reason we tend to repeat the mistakes we make much more often than is necessary.
I want to keep a record I can use to recall the mistakes I’m likely to repeat, when I have long forgotten about them – to (hopefully) take the right steps to avoid them in the future. So this post serves as a reminder to myself, but it also describes a very typical investing experience that everyone goes through in some form or other.
We should try hard to draw lessons, that we can actually implement before and during the next drawdown cycle, when positive developments have pushed memories of past mistakes away.
We should try hard to draw lessons, that we can actually implement before and during the next drawdown cycle, when positive developments have pushed memories of past mistakes away.
Ray Dalio, founder of the world’s largest hedge fund, highlights the positive impact mistakes can have, when you don’t ignore them and put it into a neat little formula:
Mistakes + Pain + Reflection = Progress
Reasons for a drawdown
The reasons for a drawdown fall into several categories that are important to distinguish, if we want to learn from them:
- Good process followed by a bad outcome = random bad luck; we have to expect this to happen – it is par for the course, but, I think, it is possible to use regime indicators to identify market environments that make bad luck more probable. We can then adjust exposure and reduce the overall losses caused by strings of bad luck.
- Bad process followed by a bad outcome = mistake; we didn’t follow our rules and avoiding these mistakes is what we should concentrate on most.
- Bad process that leads to a good outcome = mistake; this doesn’t cause a drawdown, but should be considered nonetheless – too often it is ignored. The combined number of mistakes will define their drag on return, as random luck will cancel out over time when the mistake sample gets bigger and bigger.
Portfolio analysis
By the end of June 2018 my portfolio had the largest drawdown since I started to record a track record for this blog, in an environment that looked like nothing special at all – at least on the surface. At month’s end it stood at -16,75% – it has since recovered some ground, but easily exceeded -20% intraday at times in June.
What happened?
- Changing market environment: this is extremely important to me as market regimes have the greatest influence on return over time and regime changes can be addressed in the investment process. Read the details about changes in market regime and resulting ideas on portfolio management in my next post – I will just list the essential points here:
- On February 2nd 2018 I got a strong volatility based warning sign of a possible regime change. Because 2017 was so extraordinarily quiet and previous warnings turned out to be very short term, I failed to react sufficiently.
- After some initial windfall profits in February and March, the shifting market environment resulted in essentially uncorrelated strategies moving in tandem through whipsaws caused by trade war rhetoric – causing high portfolio volatility and finally culminating in a drawdown throughout May and June.
This made up for more than half the drawdown – in line with the losses of equity markets ex US, but it could have been reduced by cutting leverage more decisively. The remainder was due to my unnecessary mistakes:
- Actual mistakes: these always boil down to the same few things. In 2017 I compiled a similar list that was leading to a small, but noticeable drag on return then:
- Good times (up until January 2018) led to overconfidence and performance chasing:
- Over-leverage in a low volatility environment makes a portfolio vulnerable to sudden reactions in the market. Failing to adjust leverage quickly and keeping it reduced for long enough, caused portfolio volatility to become too high, which in turn led to bad decisions.
- The major mistake was not to follow my exit plans: Stop losses were ignored and I even doubled down on losing positions – which is classic self-destructive behavior caused by loss aversion. This is connected to an increased illusion to be able to accurately predict short-term market movements whenever I get too close to the daily market gyrations – in reality these movements are largely unpredictable random noise.
- Overconfidence also led to the introduction of poorly tested new ideas. This time I introduced an intraday opening-gap strategy and went to full exposure much to quickly. The strategy, while it does seem to have a slight edge, turned out to show strings of losses correlated with losses in other strategies – something I didn’t anticipate.
- I also don’t really react well to short term trading: the mistake cycle above gets even more pronounced at the shorter time frame – insights I already outlined some time ago in this article.
- Spending too much time in front of the screen leads to overtrading and impatience – I take profits early and losses late, which are among the most common trading mistakes. Impulsive decisions override the rules of my strategy sooner or later and these mistakes kill all profit potential. The boring, but essential, basics of portfolio management are getting neglected.
All this culminates in a larger than necessary drawdown every time.
- In turn this drawdown triggered „revenge“ trades designed to make back lost ground as quickly as possible. Often this works, if the pullback is temporary, but in an extended change of the market environment this behavior can cause going down a deeper and deeper hole.
Overall the existence of a written investment plan and diligent record keeping did help to reduce these mistakes considerably (the year-to-date portfolio return at the time of writing in mid-July is positive at 7% – outperforming the average equity markets: US, EAFE and EM), but volatility and drawdown throughout my portfolio was still much larger than necessary.
Avoiding optimistic over-leveraging and having the mental flexibility to scale down exposure quickly according to the strength of warning signals are the most essential take-aways for me – most of the mistakes followed from over-exposure to changes in market volatility. Patiently standing back and watching the correction play out from the sidelines would have been the healthy move leading to a strong outperformance over the market.
Looking beyond raw drawdown numbers this also means that the investment plan is actually good and healthy – concentrating on improving execution could lead to good results for my portfolio in the future.
Take-aways and Solutions
- Good process should lead to good outcomes over time.
- Stick to a written trading plan at all times. I introduced a checklist I go through before taking any trade – optimal execution is difficult and mistakes creep in through the smallest cracks.
- Take responsibility for all mistakes and good as well as bad outcome.
- Analyze which part of portfolio performance is due to skill and process, which to luck. There are no certainties in investing, only probabilities and individual outcomes are random to a very large degree.
- Integrate some tricks to modify known bad behavior in your trading plan, for example: revisit past mistakes when optimism is strong; be aware that your emotions need constant taming; etc.
- Simplify the trading plan so that essential risk exposure and warning triggers are crystal clear.
- Decisively adjust leverage with the strength of warning signals: for me these are mainly the inversion of the VIX Futures Term Structure and the violation of 275-day moving averages in different markets.
- If strong and extended warning signals point to a longer lasting regime change, patiently observe the market from the sidelines. In the first half of 2018 virtually all markets showed radically different behavior from the year before – that was very difficult to deal with for an extended period of time.
- Keep a large margin buffer to be able deal with adverse moves without being forced into taking action by margin constraints.
- Built ample reserves for living expenses to avoid having to withdraw money during a drawdown.
- I´m also thinking about building reserves to restock the portfolio after a drawdown. I want to be able to take better advantage of good opportunities when a drawdown creates pockets of value in the market.
As market regime changes have such a strong impact on portfolio performance, I continue writing about it in the next article.