Drawdown: How Much Can You Afford To Lose?

Equities produce better returns than other asset classes. But corrections are part of the market. Sometimes even a real crash occurs, however that's not so bad for long-term investors – just as long as they don't panic at the wrong moment.

If you want to invest in shares, you have to think like in any game: Only those who can lose can also win. But: Can you lose as much as you want to win?

Stock market slumps don't occur regularly enough for you to set your alarm clock by them. But they are certainly part of the stock market cycle. Historically, shares have nevertheless yielded the highest returns of all asset classes. This is because not only is the crash often steep, but also the recovery afterwards.

Let's take a deeper look at this. The S&P 500 index comprises 500 stocks issued by large-cap companies. The price data goes back to 1871 – ideal for a long-term look back. We have calculated the index including dividends. This means that all dividends paid out are reinvested in shares.

Returns and Max Drawdown of S&P 500 since 1871

Losses of 50 percent or more are therefore also conceivable for anybody investing in shares over their lifetime. With gallows humour, one could say: "Those who invest in shares regularly lose half of their investment."

Here comes the good news: None of the periods with losses exceeding 20 percent has lasted longer than 13 years. This is the longest time the index has taken to recover from losses – and finally rise again above its past peak for the first time. In most cases, the recovery has been even swifter.

No loss, only a drawdown

Portfolio managers even have their own term for these dents in the portfolio: A drawdown. A loss drags us down – also emotionally. It might only spoil our mood a little. Or it might make us panic. Either way, we should prepare ourselves for an emotional reaction and be mentally ready – because a loss will come. No question of if. Just when.

If we could, we would probably all prefer to buy at the dip and sell at the crest. Buy low, sell high. But market timing is very difficult. Even the vast majority of professionals don't succeed at it.

But market timing is not even necessary. Most important is to stay invested. And thereby to also participate in the recovery. Because the gains let the losses from the crash fade away, becoming just a hiccup in the course of time.

But: Can you withstand the drawdown?

You actually have to. Without the recovery, you are forfeiting the opportunity. If you get scared when the prices collapse, there is a big risk that you sell at the dumbest time. Likely resulting in you being among the biggest losers in the game of market timing – while selling your shares to the laughing winners.

Yes, there are indeed winners and later you will find out how you can be one of them. But first, back to the question: Can you withstand the drawdown?

How much loss can you bear?

Can you stand a 50 percent loss without intervening in your portfolio? Is a 30 percent loss the threshold at which you just have to do something? Or do you sell your shares without further ado at the first turbulence of 10 percent?

If you manage your portfolio with us, then you already know this: We jointly assess your risk tolerance with a detailed questionnaire. And we do this before you start investing. And, if possible, once and for all. If your financial circumstances do not change, you should stick to your assessed risk tolerance.

If you can't stand to lose half, then you shouldn't invest 100 percent in shares. Is your loss tolerance lower? If so, then you should hold assets from other classes in your portfolio. For example bonds that do not fluctuate as much.

What exactly should be the proportion of shares in your portfolio?

We calculate this automatically from your risk tolerance. Not only for shares, of course, but also for all other asset classes. Later, we regularly adjust the proportions back to your personal investment mix through so called rebalancing. This is also known as constant proportion.

By the way, constant proportion also means that in the event of a market correction, we automatically buy back the asset classes that have suffered the most. The money for this comes from the sale of better performing assets. This is how what everyone wants happens: Buy low, sell high. Without a forecast, without market timing, anti-cyclically and done completely automatically. Those who endure the drawdown get a double reward: The profit from the drawdown recovery. And in addition, the returns from the further purchases.

Be honest with yourself

You can get this reward. But only by not panicking and staying invested. This is where you need to be ruthlessly honest with yourself for a moment: How cool will you truly stay when the crash comes?

Imagine your portfolio. Don't just think in percentages. Calculate in absolute figures what it means if your assets shrink. Maybe even by half. Do you still come up with the same result in your mind as when you first opened your account?

If not, it might be worthwhile to reassess your risk tolerance. You will discover the link to do this on the Investment Mix page just below the risk indicator tool. After doing so, you can be sure that you are providing us with the right strategy. We take care of the implementation accurately even in stormy times and keep your portfolio on course with constant proportion.

An earlier version of this article was published on the 15.02.2018

About the author