From the April 2006 issue of Investment Advisor • Subscribe!

Understanding Drawdowns

Most investors have risk tolerances substantially lower than what they indicate to their

The mutual fund industry and many investment professionals have a well-guarded secret they do not want the investing public to know about: drawdowns. Drawdowns are, in our opinion, the single most important determinant of investing success or failure for most investors.

There are many ways to measure risk and volatility in a portfolio. Some measurements, such as standard deviation and beta, may be confusing and difficult for the investor to interpret. The concept of drawdowns, however, is simple, and the calculations are not difficult either. A drawdown is defined as the loss incurred by an investment during a certain period of time, measured from its peak to its lowest point. The maximum drawdown on a mutual fund, for example, is the greatest loss experienced by a mutual fund, peak to valley, before the fund changed direction and began recouping the loss. To calculate a mutual fund drawdown, find the lowest point a fund has reached from a previous high and calculate the drop. Drawdowns are calculated as a percentage of the previous high so that they can be easily compared.

Another important concept regarding drawdowns is 'Time to Recover' (TTR). The shorter the TTR, the less agonizing the drawdown. It can take years to recover from some drawdowns, especially large ones, and if the drawdown is high enough, the investment may never recover. For example, a 50% drawdown takes a 100% gain to recover--a formidable task for most funds to achieve. One of the worst characteristics of drawdowns is that they frequently strike like tornados. They hit quickly, without warning, and cause immense damage. It's often difficult to realize their devastation until after they have struck.

To be a successful investor, your client must be in a strategy where his risk tolerance can 'stay the course' and ride out drawdowns. We have found that most investors have risk tolerances substantially lower than what they indicate to their advisors. To make matters worse, most publications and mutual funds fail to disclose drawdown data.

One top business publication recently rated their Top 20 Mutual Funds. But despite these funds' stellar long-term track records, all had drawdowns of over 25%, and some were over 40%. We believe that most investors find drawdowns of over 20% to be an unacceptable loss for a mutual fund or investment advisor. Moreover, many investors believe in limiting their losses to substantially less than 20%.

So what should investors do if they want investments that earn more than the returns of fixed- income investments, yet don't want to see their portfolios devastated by drawdowns? While there are different solutions, we think the answer is limited-risk investing using convertible bonds and principal-protected products deployed in an absolute return strategy. According to Value Line, "Convertibles are safer than stocks, yet more profitable." Why? Because high quality convertibles generally do not have the horrendous drawdowns that most mutual funds and stocks sustain.

Greg Miller, CPA, CEO

Wellesley Investment Advisors, Inc.

Wellesley, Massachusetts

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