Improving Your Investment Strategy with the Drawdown Analysis

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( — February 27, 2018) — Among the most important qualities of a successful investor is patience. However, there is also a danger of being overly patient. It is essential that you have a strong understanding of the stock market dynamics in order to achieve a good balance of patience and timely action. As with other areas of life, you need to learn from the mistakes that you will inevitably make when investing in the stock market.

Drawdown analysis is one of the areas in which online stock traders tend to make mistakes. Successful trading involves, among other things, making good judgments during a drawdown phase. Important areas of your life are marked by periodic ups and downs and it’s no different with trading where bear and bull periods are inevitable. The way one handles these situations distinguishes the winners from the losers.

You need both financial analytical competence and psychological skills to be able to handle a persistent downward trend in the market, and more specifically, in your investment portfolio. Investors who emerge victorious are typically the ones who never lose faith in their investment strategy and philosophy.

Historically, too many seemingly smart traders have allowed their fear to rule and dropped some positions during a drawdown on for the price of the stock to suddenly shoot upwards. As a result of poor skills in drawdown analysis, they end up running into a major setback on their path to achieving their investment goals.

Drawdown analysis versus traditional portfolio performance analysis

Billionaire investor Warren Buffet described the stock market as a device for transferring wealth from impatient people to patient people. To learn the point at which you should get out of an investment, look back at the history of your portfolio and identify the levels it hits before it starts to rise again.

In technical terms, a drawdown refers to the peak-to-trough decrease of a commodity, fund or investment for a recorded period. Usually, it is expressed as a percentage between a peak and a trough that follows. You can learn more about drawdown analysis on

The drawdown analysis is useful for measuring your investment portfolio’s financial risk. Compared to traditional measures of the performance of a portfolio, the drawdown analysis is far superior. Many investors typically measure their returns of their portfolios over a specific period, such as a month or a year.

However, a drawdown analysis measures the performance of your trading portfolio based on the recent highest point. For example, consider a portfolio that starts out at$10,000. Its value increases to $15,000, drops to $8,500, rises to $11,000, drops to $7,000, and then shoots up to $19,000.

The maximum drawdown for the above portfolio would be [($10,000 – $7,000) / $10,000], which is equal to 30 percent. Unlike traditional measurement of portfolio performance, the calculation for maximum drawdown doesn’t include the $19,000 highest point because the drawdown began at the $10,000 point. Similarly, the increase to $11,000 before the decline to $7,000 is not included in the calculation because it wasn’t a new peak.

A professional investor protects their investments the same way a mountaineer nails their rope as they climb to make sure that they don’t fall all the way to the ground in case things go wrong. As with the case above, benefiting from a substantial increase only to lose most of it shortly after is no cause for celebration. During a decline, stop losses help to secure your profits.

The traditional way of keeping track of your performance is not as useful as a drawdown analysis when it comes to improving your performance. When the market begins to perform well, investors who use the drawdown analysis have a strong advantage over those who fail to use this measure of protecting profits.

Back-testing your investment strategy enables you to learn the maximum drawdowns in your portfolio. You can then use that as the maximum downward trend you are willing to bear as a trader. It is certainly not necessary to keep taking losses until you reach your threshold point, the drawdown exit strategy greatly minimizes the amount of risk you expose yourself to.

Painful as they may be, mistakes are among the most effective ways of learning how to trade successfully. Avoiding old mistakes that you and others made is the path to financial independence.

Dealing with a drawdown

No matter how good you are at trading, you cannot make a profit on every trade. Rarely does an investor make profits for several months at a time. Investors with the best-performing trading strategies occasionally go through brief periods of loss-making. When this happens, they seek to understand the cause and how to recognize that and avoid those events in the future.

On the other hand, traders who experience losses as a result of their lack of discipline find it difficult to handle those losses. These are typically the kind of traders who are never content with any profit size. Consequently, they hold on to positions for too long, hoping to make up to the last penny from an upward trend. Some are also unwilling to cut their losses and some change their trading strategy too often because of lack of discipline.

Final thoughts

The performance of your investment strategy will be determined by the nature and frequency of your drawdowns, i.e. periods of unprofitability. Drawdowns that are relatively small and infrequent usually lead to success, whereas substantial drawdowns that happen frequently result in unhappiness.

While the drawdown may be discouraging for a well-funded and highly experienced trader, it’s usually not fatal. Drawdowns are usually catastrophic only for undisciplined, stubborn traders who are averse to taking corrective actions even after an extended downward trend.

Full time traders rely on their trading activities as a source of livelihood. When losses become the norm rather than the exception, and a drawdown persists for too long, the business is no longer sustainable for traders. That’s right—trading is a business.

Drawdown analysis is just as crucial for part-time traders who are only dabbling in the business. You’re on the path to financial security. Therefore, proper planning, risk management and a high level of discipline are what you need to get there.