Drawdowns – Can they help you?

I always assumed that it was generally “good” for a client to reallocate their funds when there were big moves in the market. I say generally because sometimes big moves are very short, or technical, occurrences that don’t hold any weight (think flash crash). It is the “buy low” adage.

I wanted to back this adage up with some numbers, so I decided to do my own experiment. I must say, I was just as surprised at the results I found as I am every time I flip on the TV and see that Donald Trump is still a presidential candidate (seriously?? How many bankruptcies has that “successful businessman” declared?).

Before I lay out the experiment and results, however, I want to reiterate what every one of my posts ends with. This is just for informational use only. Take it for what you will, but don’t expect the next twenty years (and future recessions) to behave exactly like the last twenty years. Wasn’t it Mark Twain that said, “History doesn’t repeat, it rhymes”?

 

Here are the four investments within the experiment

 

  •         S&P 500 Total Return
  •         US Barclays Aggregate Bond Total Return
  •         Balanced Portfolio
  •         Tactical Portfolio

 

The balanced portfolio consisted of the S&P 500 and the US Barclays Aggregate Bond. Every year it starts off invested in 50% of each of those two investments. At the end of the year, it reallocates back to a 50/50 split.

The tactical portfolio is a little trickier. It also only invests in the S&P 500 and the US Barclays Aggregate Bond. It starts the same way as well, invested in 50% of each fund, and rebalances back to a 50/50 split at the end of every year. However, there is a “trigger” that causes a difference in the allocation. That trigger is a 10% drop in the S&P 500. When there is a 10% drop from a high in the S&P 500 price, 5% of the portfolio is moved from the US Barclays Aggregate Bond into the S&P 500. If there is another 10% drop (so a total of 20% from the high of the S&P 500), there is another 5% reallocation. This continues with every 10% drop. In order for the equity exposure to be lowered, the S&P 500 must reach its previous high. I will give a brief example:

  1.       S&P 500 price is 100.
  2.       Price drops to 90.
  3.       Move 5% of the portfolio from US Barclays Aggregate Bond to S&P 500
  4.       Price drops to 75.
  5.       Move another 5% of the portfolio from US Barclays Aggregate Bond to S&P 500
  6.       Price rises to 95
  7.       Do nothing
  8.       Price rises to 100.
  9.       Move 10% of the portfolio from S&P 500 to US Barclays Aggregate Bond.

I ran this experiment starting 12/31/95 until the end of October of this year. Below are the results.

Drawdown

As you can see, the S&P 500 had the highest total return. However, if you factor in the volatility that came with that return, the S&P 500 actually performed the worst. It has the lowest Sharpe ratio. The best “risk-adjusted” return goes to the US Barclays Aggregate Bond. However, you can see it actually had the lowest overall return of the four investments. I don’t want to focus too much on this risk-return tradeoff as that is a separate discussion in itself.

What I found most surprising was the lack of return of the Tactical portfolio versus the Balanced portfolio. Sure, it returned a higher total return (4%!!!!), but it took on more volatility than the Balanced portfolio. You can see that in a down year, the Tactical portfolio under-performed the Balanced portfolio, but it recovered faster in the recovery phases.

To give you some detail behind the charts, in 2000 there was a 10% drop from the S&P 500 high price with no recovery. In 2001, the price continued to fall another 10%, then another 10% (so over 30% drop from its high in 2000). By mid-2002, two more 10% drops occurred. Therefore, from about March of 2000 to July 2002, the S&P 500 dropped more than  50% (not quite reaching 60%).

Based on my rules that I established for the Tactical portfolio, we would have reallocated 5% of the portfolio to the S&P 500 five times, and all five times the S&P 500 price keeps on falling.

It took until around mid-2007 to reach the high price of the S&P 500 from 2000. Therefore, we moved 25% of our portfolio from the S&P 500 to US Barclays Aggregate Bond. Now this is ironic…within a couple months of obtaining that high price, the S&P 500 once again started dropping, and did not stop dropping until March of 2009. This was the Great Recession.

Again, the S&P 500 lost over 50% of its value at one point, but did not quite reach a 60% drop. It took until around April 2013 for the S&P 500 to recover to its previous high. This time it continued its rally without a 10% drop until this year in May, when it set a new high. By August, it had dropped by over 10%, setting off a trigger for the Tactical portfolio. However, most of this drop in price was recovered in October.

The biggest issue with the Tactical portfolio over the last twenty years is that when the S&P 500 has fallen 10%, more times than not it has continued to fall. Perhaps a 10% trigger is too small. What happens if we increase the trigger to 20%? Therefore, we only reallocate every 20% drop in the S&P 500 price. Below are the results.

Drawdown 20

The results are actually worse!

Okay, last try. Originally, when the S&P 500 reached its previous high after those large drops, we simply moved the percentages that had been moved to S&P 500 back to the US Barclays Aggregate Bond. For example, after a 50% total drop in the S&P 500 we would have allocated an extra (5% x (50/10)) 25% toward equities. Now that the price had recovered, we would move 25% of the total portfolio into US Barclays Aggregate Bond. Instead of doing that, what if we rebalanced to a 50/50 split between the S&P 500 and the US Barclays Aggregate Bond? Below are the results.
Drawdown 5050

Ahh!!! The results improved! However, the Tactical portfolio earned a better total return of only 12%…over twenty years. Nothing to brag about. And its Sharpe ratio was still worse. Another issue that we are facing is a form of data mining. We cannot simply back-test our portfolio and adjust until we receive superior results. Why? Because the next twenty years will not behave exactly as the last twenty years.

What does this research tell us?

Right away, I would say that simply switching your allocation due to price drops is wasted effort. You should use valuation or momentum techniques to know when to reallocate. However, that is a separate discussion.

This data should reiterate how much volatility occurs in the market. Investors tend to have short-term memory. More than six years have lapsed since the over 50% pullback from the last recession, and I’m sure people will point to that recession and say it was an outlier. However, all you have to do is go back another five years and there was ANOTHER 50% pullback from the dot-com explosion.

Another hindrance is that the returns that investors observe do not shed light on the depths of those two pullbacks. Why? Almost all returns presented to investors will be calendar year returns, or rolling year returns. This disguises the true nature of the beast, so to speak. Look up at my first chart. Under the S&P 500 column, you do not see any negative returns around 50%. Even if you sum the 2000-2002 returns, you only get around 43%. BOTH of the last two recessions barely missed hitting a 60% drop.

This leads into something else the numbers do not show: The emotions that investors were (will be) flooded with at the depths of those (future) pullbacks. When the S&P 500 was down, say, 55%, do you believe any investor was thinking, “Okay, now the market will recover.” Sure, there were astute investors who looked long term and thought the market would recover. However, I doubt even they would be comfortable increasing their equity allocation. And I would say a high percentage of investors bailed then, if not sooner, and sat in cash. They then missed the inevitable recovery that occurred.

It’s not during the good times that an investor needs a financial advisor, it’s during the bad times. And hopefully that advisor is competent.

Just a prelude to my next article. In the second chart I presented, the total returns for the Balanced and Tactical portfolios were 313% and 311%, respectively. However, if you look at the side chart you will notice the “average” return for the same portfolios were 7.71% and 7.79%, respectively. How does a portfolio have a higher total return, yet a lower average return?!?! More to follow…

 

Adam McCurdy, CFP®, EA

 

As always, this if for informational and educational purposes. Nothing contained herein constitutes tax, legal, insurance or investment advice, or the recommendation of or an offer to sell, or the solicitation of an offer to buy or invest in any investment product, vehicle, service or instrument. What has worked in the past may not work in the future. Past returns do not guarantee future results.

Adam McCurdyDrawdowns – Can they help you?

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