One of my favorite heuristics for determining an investor’s willingness to take risk and, subsequently, an appropriate asset allocation, is to ask what magnitude of portfolio drawdown they are comfortable with. While the actual future drawdown profile of investment portfolios is unknowable, we can look to historical drawdowns of various asset allocations to arrive at a starting point. In this post, I explore the drawdown profiles of simple asset allocations.
To conduct this analysis, I used Portfolio Visualizer (www.portfoliovisualizer.com), which is an excellent freemium back-testing tool. For simplicity’s sake, I made the following assumptions:
Equity Allocation is “U.S. Stock Market.”
Fixed Income Allocation is “10-Year Treasuries.”
Portfolio is rebalanced annually.
Analysis conducted in the January 1972 to May 2021 timeframe.
The max drawdown analysis section will show the “Max Drawdown”, “Underwater Period”, and “Drawdown Period.” The “Max Drawdown” is the change in portfolio value from peak to trough during the drawdown. The “Underwater Period” is how long it took the portfolio to recover the initial peak value. Lastly, the “Drawdown Period” is the market event in which the drawdown occurred. The detailed analysis section will show the differential performance of a 100% equity, 60% equity / 40% fixed income, and 25% equity / 75% fixed income portfolio during different periods of market stress from the last 40 years.
There are several other factors that would affect the analysis, including but not limited to:
Size, value, geography, and sector tilts within equities would affect the results.
Longer duration treasuries would improve performance in the Global Financial Crisis drawdowns but worsen them in the 1970-1980’s inflationary period – and vice versa for shorter duration treasuries. Any credit exposure, such as corporate bonds, would worsen drawdowns in times of stress.
The latter part of the lookback period was a favorable period for global fixed income, as it provided a significant buffer during equity drawdowns. Given the low current level of interest rates, the benefit is unlikely to be the same going forward.
Changing the rebalancing frequency or timing can affect results, especially during volatile periods such as the Global Financial Crisis.
Results in nominal dollars – if you adjust portfolio values for inflation, drawdowns will be larger.
Max Drawdown Analysis
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The foregoing table confirms what one would expect: historically there has been a direct correlation between equity-weighting and the extent and duration of portfolio drawdowns. Fixed income heavy portfolios struggled during the inflationary period of the 1970s and 1980s.
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I want to emphasize again that these results should not be interpreted as max drawdown for a given asset allocation. To make this point, although the 2020 drawdowns generally did not exceed Global Financial Crisis drawdowns, they set several records, particularly related to the velocity of the sell-off. That said, when meeting with a client or prospect and attempting to determine their risk tolerance, reviewing historical drawdowns by allocation is a great place to start.