False expectations lead to a great part of the emotional and financial suffering that traders and investors encounter in the markets. Members of the first group are preponderantly misled by alleged professional traders (who can’t substantiate most of their claims and have no verified track-records) while in the case of investors, advisors with conflicts of interest play an important role.
Drawdowns, periods when a trading strategy loses money, are a reality of being involved in the markets that many just gloss over, if they mention it at all. But if you are aware and really understand this fact of trading and investing, your life will be much easier.
Forewarned is forearmed
In my opinion, if you expect drawdowns to be no more than 10% and last no more than a month or two, you’re deluding yourself and probably shouldn’t be trading. If you’re an investor/asset allocator and you think you’ll be able to jump from manager to manager right before they enter a drawdown, you just set yourself for a lot of grief further along the road.
You know the saying, a picture is worth a thousands words, so please look carefully at the 2 photos below:
Warren Buffett needs no introduction. Even though he’s the world’s richest and most famous value investor, we can see his sailing to the top hasn’t been smooth. Since 1980 his investment vehicle, Berkshire Hathway, experienced a couple of -37% drawdowns and two ~ -50% ones.
Dunn Capital is a trendfollowing CTA currently managing $542 millions with a long history which goes back to the 1970s. This year they’ve taken the 4th place in Barron’s Best 100 Hedge Funds list. One interesting aspect that caught my eye when looking at its page on BarclayHedge.com is that up until 2013 this fund had a fixed risk target of 20% VaR, the same as DARWINs have.
Since 1984, Dunn has compounded money at an annual rate of 14.17% (net of fees). But to achieve this performance, the firm and its investors had to endure some brutal drawdowns: for instance -27.5% during the 14 months between August 2011 – October 2012 or -44% during the 12 months between September 1999 – September 2000.
To conclude: in the financial markets, as in life in general, if something sounds too good to be true, it probably is. Throwing caution to the wind and ignoring history is what allows a myriad of hucksters or frauds a la Bernie Madoff to fleece their unsuspecting victims.