All investors want to maximize their portfolio’s returns while minimizing their risks. But how should you measure ‘risk’? Standard risk measures, such as Volatility or Value-at-Risk (VaR), provide only limited information about the risk your portfolio is exposed to.
The most common measure, Volatility, has a number of drawbacks (which we wrote about in a previous Risk Letter [1]), but the most important is that the measure ignores the sequence of returns; High Volatility can be good in rising markets, and Low Volatility can be bad when it results from steady losses. As a measure of risk, Volatility simply does not provide enough information about a portfolio’s historical or potential losses.
In this Risk Letter, we present the Maximum Drawdown, and recommend it as a complement to, and possibly even as a replacement for, standard risk metrics such as Volatility and VaR. Because Maximum Drawdown represents the worst loss suffered by a portfolio from its previous highest point, it focuses squarely on the most important risk investors’ face: losing some or all of their capital.
Maximum Drawdown is Active Asset Allocation’s preferred risk measure. For more than five years, we have actively promoted it because we believe that good money management necessitates minimizing capital losses. Additionally, minimizing downside risks provides significant benefits to both investors and their asset managers because it perfectly aligns their interests. By preserving their clients’ capital, asset managers preserve their fees.
We hope to convince you to add Maximum Drawdown to your menu of risk metrics, and to add the active management of downside risk to the heart of your asset allocation process.