Max Pain – Investing, not the Awful Movie

When I get bored I crunch numbers and build spreadsheets just like everyone else.  This time I wanted to see the maximum amount of money an investor would have lost over the last 40 or so years.

It’s an important number to me for 2 reasons:

1. How far is the deviation from what one would expect given the historical average and standard deviation (i.e. variance around the average)?
2. Investors tend to panic when the losses get really bad.  The results in a sell at the bottom mentality, locking in the already large loss.

Here is what we got:

Let’s breakdown US Stocks (i.e. S&P 500 month-end values, dividends reinvested) because that is what most people care about: 

• From 1970 through April of this year stocks had an annualized return of 10% with a standard deviation of 16%. 
• To elaborate, that means 95% of the time we can expect stocks to fall between -22% and 42% return in a 12-month period. 
• While the max drawdown was 51%, over a full 12 month period that number drops to 41% (not shown).
• During that time frame, the lowest return over a 10 year period for stocks was -29% (also not shown).  This sticks out as there have been 10 year holding periods where investors could lose money by holding equities.  There were 24 times this happened; however, they were all consecutive and took place between 2008 and 2010 corresponding with high equity values (e.g. the start date) prior to the tech bubble.

Risky assets (stocks, REITs, commodities) all have large drawdowns and are relatively correlated (again, not shown) with the exception of maybe commodities.  Thus, diversifying from just US Stocks to other risky assets will most likely not be an adequate hedge in the event of a large drawdown in US Stocks.  The addition of bonds helps; however, from my data is no panacea. 

 Note: Portfolios are rebalanced annually.  For a breakdown of the allocations and the indices used please email me for details.

The above numbers indicate that portfolio diversification can lessen risk (i.e. standard deviation) without sacrificing much, if any, return.  However, the max drawdowns are still large and well outside 2 standard deviations.  So while a diversified portfolio can mitigate maximum drawdown risk, it doesn’t necessarily restrict it.   This leaves the investor with 2 choices:

1. Mentally prepare himself or herself for a large drawdown so that if it does happen he or she doesn’t liquidate at the bottom and lock in a devastating loss.
2. Put risk control measures in place so the max drawdown is limited.  

Past performance is no guarantee of future results.  Diversification does not guarantee a profit or protect against a loss. International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties. The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts, Inc. or Lincoln Investment.