Normalising Drawdowns

In the world of trading, drawdowns are not a matter of if, but when. They're an inevitable aspect of navigating the unpredictable terrain of market fluctuations, a reality every trader must confront.

This post aims to normalise drawdowns, shedding light on their inevitability and countering the prevailing notion that only double-digit drawdowns are abnormal. Let's delve into the psychology of drawdowns and compare these experiences to the broader market landscape, notably the S&P500.

Remember, it's not about avoiding drawdowns but learning to navigate them on the path to long-term success.

Drawdowns test not just your trading acumen but also your emotional resilience. It's during these periods of adversity that the mental fortitude of a trader is truly put to the test. The fear, doubt, and anxiety that accompany drawdowns can often cloud judgment and lead to irrational decision-making. Yet, seasoned traders know that drawdowns are an intrinsic part of the journey towards consistent profitability.

Comparing to the S&P500: Even the broader market, represented by the S&P500, experiences drawdowns. Understanding the magnitude and frequency of these drawdowns provides perspective and reassurance to individual traders facing similar challenges, especially as we strive to outperform the benchmark of typical buy-and-hold strategies.

Below shows the yearly drawdowns in the S&P500 since 2000. 15 out of the 23 years (65%) have drawdowns into double digits. The average across this period is 15.75%. 

Hedge funds such as Long-Term Capital Management (LTCM), Tiger Management, Bridgewater Associates, and various quantitative funds have demonstrated that they are not immune to significant drawdowns. During turbulent market periods such as the Russian financial crisis of 1998, the bursting of the technology bubble in the early 2000s, and the global financial crisis of 2008, these funds faced drawdowns ranging from 20% to as high as 44%. These examples underscore that even large and sophisticated hedge funds are susceptible to drawdowns far beyond single-digit percentages. It highlights the importance of risk management and adaptability in navigating the complexities of the financial markets.

Social Drawdowns: One common pitfall among beginners is the failure to normalise drawdowns. Social media often portrays a highlight reel of trading successes, leading many to believe that drawdowns are abnormal. However, the reality is that drawdowns are an inherent part of trading and should be expected.

In addition to social media, we now have funding challenges many retail traders are trying to exploit, also contribute to the stigma around drawdowns. In these funding challenges, double-digit drawdowns are often deemed unacceptable, further perpetuating the myth that drawdowns should be avoided at all costs. As a result, traders may be inclined to abandon proper trading strategies and instead opt for buying a new challenge when faced with significant drawdowns. However, this approach fails to impart the invaluable lessons that drawdowns offer and undermines the development of crucial resilience in traders.

The Road to Recovery: Recovering from a drawdown requires not just patience but also a clear strategy. By looking back at historical data and backtesting results, traders can gain a more realistic understanding of what constitutes a "normal" drawdown for their trading system.

The table below illustrates the relationship between drawdown %'s and the subsequent % returns needed to recover.

Conclusion: Drawdowns are an unavoidable aspect of trading, but they needn't be feared. By understanding the psychology behind drawdowns, learning from the experiences of experiencing them first hand, and normalising drawdowns within our trading community and framework, we can navigate these valleys with greater confidence and resilience.