With yet another quick rebound in the stock market up towards all-time highs (does anyone remember how dire things looked in February), investors have once again been spared the pain of a long period between new highs in the stock market. These valleys between new all-time highs are called drawdowns in the business, and when you see charts like the one below from Ben Carlson’s wonderful post showing stocks have been moving up and to the right since the early 1800s, you could be forgiven for thinking stocks are hardly ever in such valleys.

S&P 500 1850s(Disclaimer: Past performance is not necessarily indicative of future results)
Chart Courtesy: A Wealth of Common Sense

But upon closer inspections, there’s an awful lot of those red spots along that line. The most noticeable red is during the Great Depression, followed by the dot-com bubble, and the housing crisis (pretty crazy to think two of the worst ones were this recent). But as Carlson points out, we actually spend more time in a drawdown than we do hitting new highs.

Stocks don’t make new highs every single day, so most of the time you’re going to be underwater from your portfolio’s high water mark. This means there are plenty of chances to be in a state of regret when investing in stocks.

This makes sense when you consider that stocks are positive just a little over half the time when looking at returns on a daily basis, but it can be difficult to wrap your head around this fact.

To make the visuals easier to see just how bad those red areas are, Carlson converted it to an underwater equity curve, to show how much or a drawdown the S&P 500 experienced since 1927.

SP 500 1927 Drawdown Chart(Disclaimer: Past performance is not necessarily indicative of future results)
Chart courtesy: A Wealth of Common Sense

This chart sure looks worse than the first one…  with drawdowns of -40%, -50%, and -80% making our stomachs turn. And you can’t help but notice here how much of the time those big blue ‘icebergs’ are poking below the 0% line. Which begs the question, just what percent of the time has a stock market investment been “underwater?” Back to Ben:

… an investor would have been down from a prior peak over 70% of the time. The majority of your time invested in stocks could be spent thinking about how you coulda, shoulda, woulda sold at that previous high price (which of course gets taken out to the upside eventually).

Here’s the further breakdown by the size of the loss:

Stocks Percent of Time in drawdown

Think about that for a second. Stock market investors have historically been down at least 10% from their high more than one-third of the time. If an alien landed on Earth and invested in stocks starting in 2009, they might think you had two heads (like him) quoting that stat.  And we know another group of investors who might think stock folks are crazy for enduring these big, and long, drawdown periods – those invested in alternative investments which actually try to control risk. If we look at our favorite alternative investment, managed futures, as compared to stocks – you see a tale of two different icebergs. While we don’t have data going back to the 1800s or 1920’s, the Dow Jones Credit Suisse Managed Futures index started in 1994, providing 20+ years of comparison.

Stocks Managed Futures Underwater Equity Curve

Managed Futures certainly wins when it comes to minimizing drawdowns, with the index’s worst drawdown standing at just -17.74%, while the housing crisis (2007-2008) caused stocks to lose half their value (-50%). But how much can investors expect stocks and Managed Futures to be in a drawdown? Here is our version of Ben Carlson’s drawdown table.

Stocks Managed Futures Percentage Time in Drawdown

Think about this for a second, stocks were down 20% or more about 1/3 of the time over the past 20+ years (slightly higher than average thanks to two bubbles bursting), while Managed Futureswas never down 20% (you know, 0% of the time).  You can clearly see the different return profiles of stocks and alternative investments in this exercise, with Managed Futures being down a small percent more of the time than stocks, and stocks being down a bigger percent more of the time than managed futures. That’s the game each plays – with stocks trading consistent up and to the right movement for periods of sharp downturns (and long recoveries), and managed futures trading extended flat to down periods for sharp upturns.

Ben’s closing argument?

No one can predict what the future returns will be in the market. No one knows what the future holds for economic growth. And we certainly can’t predict how investors will decide to price corporate cash flows at any given point in time out into the future.

But predicting future risk is fairly easy — markets will continue to fluctuate and experience losses on a regular basis. As an investor in stocks you will spend a lot of time second-guessing yourself because your portfolio has fallen in value from a previously seen higher level.

In a sense risk is easier to predict than returns.

Market losses are the one constant that don’t change over time — get used to it.

We couldn’t agree more. You can’t predict returns. And no matter the investment – you’re likely to be in some type of drawdown more often than not. But that doesn’t mean you can’t take aim at controlling the amount of risk you’re exposed to.  The textbooks would tell us that sophisticated investors would prefer, all else being equal, to lower the drawdown magnitude and time to recovery. We’d like to think that a balanced portfolio would provide an investor with a risk control that beats the field and produces an optimal reward {Disclaimer: Past performance is not necessarily indicative of future results}.