Managing Drawdowns Is the Key to Keeping Your Account Near Highs
Let's discuss the discipline most investors ignore, two steps in the process, and the powerful tactic that leads to success.
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The power of compounding is what creates great market wealth. Last week I discussed how important it is to make sure that your accounts keep hitting new highs. Making up losses can set back your progress for years because it robs you of the time and benefit of compounding.
The theory is easy to understand. If we want to enjoy the power of compounding, then we have to keep accounts as close to highs as possible so we do not waste time making up losses. The hard part is actually doing it. How do we avoid sizable pullbacks and the time and effort it takes to get back to highs?
Before discussing strategies and tactics, it is essential to understand drawdowns. A drawdown is the decline from your account's peak. It is the amount of capital you have to recover to return to highs.
Drawdowns are inevitable. The only way to avoid them entirely is to take no risk at all. You are unlikely to experience any drawdown in a bank account, but you are not likely to see any substantial returns either.
The first question to consider is what constitutes an acceptable drawdown. That depends on your trading and investing style. The more aggressive your approach, the greater the potential drawdown. A maximum drawdown of 10% may work for conservative investors in lower-risk positions, but a 30% drawdown may be acceptable for aggressive traders in high-volatility stocks with high betas. Much will depend on stylistic factors like diversification, concentration, and time frame.
If you are shooting for returns that exceed the indexes, you have to be willing to live with higher volatility and bigger drawdowns. You will get burned and suffer some significant losses at times, but if your approach is sound, you will be able to make up those losses fairly quickly with new trades that work.
The more difficult problem is when the drawdown is disproportionate to the volatility inherent in your style. If you are using a conservative approach and aiming for 10% annual returns, a 30% drawdown puts you in a very difficult situation.
Once you have a feel for the average drawdown that your trading style produces, you can start to design a system that uses reasonable stop levels to prevent losses from growing too large.
Setting Stops
Setting stops can be extremely difficult and frustrating because they will never be perfect. Your stop level will often be the exact low for the stock because that is how the Market Beast operates. In retrospect, you will feel like a fool for selling your great stock when you did. So the next time it starts to sink, you will be inclined to ignore the stop because the stock is sure to bounce right back. That lack of discipline will occur just as the stock continues to drop like a falling safe.
The first step in keeping accounts close to highs is figuring out effective stop levels. Some traders use a fixed percentage, such as 8 or 10 percent. For high-growth momentum stocks, it is often too tight, so I tend to give my high-volatility names more room. I will discuss this in much greater detail in future columns, but put in place some reasonable stops and treat them as firm.
The second step is discipline. Honor those damn stops. Do not ignore them. Do not come up with justifications for suddenly changing them. It is what separates successful traders from unsuccessful ones.
The Stop-and-Rebuy
One thing that can make stop discipline considerably easier is the rebuy. Just because you are stopped out does not mean you cannot buy the stock again. The stop-and-rebuy tactic is extremely powerful. Once you are out of a position, it relieves you of a substantial amount of emotional baggage, and you can be much more objective about the wisdom of getting back in. Does the stock still hold the same attraction after you have sold it?
Investors often fail to recognize how much relief comes from exiting a stock that has been causing anxiety. It is very easy to underestimate how much emotion is interfering with a balanced view. If you do not own it, the analysis is far more objective.
The biggest problem with the stop-and-rebuy tactic is simply doing it. It takes time, effort, and planning. You not only have to set reasonable stops, but also continue monitoring the stock and evaluating it for reentry. That is considerably more work than telling yourself this is a great stock and you are going to hold on no matter how deep the drawdown gets.
There are many nuances to the stop-and-rebuy approach, but the most important thing is to embrace the concept if you want to limit portfolio drawdowns. The only way to keep accounts close to highs is to cut losing stocks before they do sizable damage.
Successful investing always comes back to the same fundamental truth. Higher returns require greater risk. There are tactics that can reduce that risk, but they come with the cost of strict discipline that demands time and effort.
Related: Six Things Most Investors Should Be Doing Now — But Aren't
At the time of publication, Rev Shark had no positions in any securities mentioned.
