Are you swimming naked?

One of Warren Buffett’s lesser known quotes is:

“It’s only when the tide goes out that you learn who has been swimming naked”.

Like most of Warren’s sayings it’s an analogy for business. Everyone looks well equipped when we’re all standing on the sandbank at high tide (analogous to bull markets and rising asset prices), but when the tide goes out it will become apparent to all that some are not so well equipped, or not wearing swimmers! (analogous to an asset correction).

Buffett’s quote is more related to company debt and those that are leveraged heroes in rising markets but inevitably prove to be reckless debt addicted miscreants when the rainy days eventually come.

This all leads into the topic of drawdowns. Do you know what the drawdown statistics on the fund/funds/ETF’s/LICs you are invested in are?

If not, you should ask your Fund Manager.

Not everyone is familiar with what drawdown means. It’s simply the peak to trough loss you experience in an investment (i.e. biggest gap between the highest price to lowest price over a chosen time frame). Let’s just look at the ASX200 Index for example to see what its biggest drawdown has been in the last 5 years. We’ll use the S&PASX200 Total Return Index (which included dividends) for the example.

So, the ASX200’s biggest drawdown over the last 5 years has been 17%. So, if you’d made an investment of $100 (ignoring transaction costs) in April 2015, 10 months later that would be worth $83 for that aforementioned drawdown of 17%. In light of the raging 10-year bull market we’ve been in and the purported benefits of diversification of an index investment, I’d say that was a pretty large drawdown, particularly if you had to sell.

People may say “Why does it matter, I’m not going to be a seller on the lows”, but it’s actually a little more complex than that. It’s a bit like an engine and how hard it has to work. When you’re driving on a nice flat paved road your vehicle doesn’t have to work particularly hard to get you up to, and keep you at, a speed that gets you to your destination in good time.

However, when you decide to head on to the sand that engine has to work so much harder to get to that same speed. So, to bring it back to investments, if your portfolio has a significant drawdown (or higher than peers or averages), it has to work so much harder to get back to where it was.

For example, heavens forbid there was another Great Depression and stock prices fell say 75% again that 75% fall would mean that your portfolio would have to rise 300% from that point of decline just to get back to where it was. Or a decline of 50% needs to see a 100% appreciation to get back to zero.

The examples above are quite dramatic so let’s look at something much more mentally manageable. Let’s pick an arbitrary lower decline of say an 8%. An 8% drawdown only requires a positive movement of 8.7% to get back to square. I hope these examples above illustrate the importance of the drawdown characteristics of portfolios.

Again one may say “yeah but it was at that value before so it’s not that hard to see it just bounce back to where it was”……but, but, but, your portfolio may look quite different (or suddenly on a sandy road) in a different economic environment that may have precipitated the drawdown; whether it be because of the shackles of debt, the vagaries of cyclicality, or changing consumer preferences. So, your engine may now not be able to generate the required output to get you back to where it was.

At the point of drawdown and manifold stress you could change your portfolio; or if you believe prevention is better than cure, you could just get a portfolio in the first place that has exhibited lower drawdowns. This is where we all throw in the quote “History doesn’t repeat itself, but it does rhyme”.

Let’s look at the drawdown statistics over the past 5 years of the largest 30 (by market cap) of the 112(!!) LIC’s listed on the ASX (or less than 5 years if they haven’t been listed for 5).

Source: Bloomberg (note these figures include dividends/distributions paid, so it’s an accumulation data set).

I’m not saying any, or all of the above funds are good or bad, and we haven’t analysed their returns, I’m just pointing out the statistics on drawdowns as measure or proxy for the likelihood of greater levels of capital protection. Now some may say “yes but some of these are boring old products that are designed for low volatility, so this comparison is not useful”.

However, design is exactly the issue I am highlighting. Design is a critical element to any product you buy, whether it be furniture, investment products, tech products – just ask Steve Jobs and Jony Ive how important design is. If you look at the drawdown statistics of your investments it will likely give you the first bit of information on design elements that you should be seeking.

I implore you to go and look at/ask for the historical drawdown statistics of the funds/investment vehicles that you are invested in (whether they be listed or unlisted) and think about whether you want more or less money as a proportion of your investments in the funds/vehicles that have evidenced lower drawdowns in the past. I’m not going to say which way I’d go as that might be construed as advice, but I’m sure you can work it out.

Keep your togs on!