Fear of Draw Downs

A common term used in the investment world is “draw down”. It simply refers to the amount that your stock portfolio went down in value, which was caused by a correction, dip, crash or bear market in the stock market.

Investors panic over this. They care more about this than gains. That is, their fear emotion about this is stronger than their greed emotion to make money.

Consequently, investment professionals, such as hedge fund managers and investment advisors are very acute to this and try to minimize it. In fact, they have “mandates” to do this, otherwise they lose clients or get sued by clients. Hence, they hedge and create balanced portfolios with fixed income.

However, this is the major factor that causes under-performance, as explained in my article Why Most funds Underperform. Many investors are willing to forego gains in order to avoid draw downs.

Warren Buffett wrote an article about students of Ben Graham and David Dodd, who became super-investors:

The Superinvestors of Graham and Doddsville

These students became full-time fund managers who outperformed the market, by approximately 8-16% per year on average. However, they under-performed in these years (corresponding to lists in their tables):

  • Walter Schloss:  1, 9, 16, 17, 19, 24
  • Tweedy:  8, 14
  • Sequoia:  1, 2, 3, 4, 9, 10  
  • Charlie Munger:  3, 8, 10, 11, 12
  • Pacific:  5, 7, 8, 9, 10, 15

So, even if you under-perform some years, you can become rich from the stock market. Buffett is the only fund manager who did not under-perform a single year.

They all became rich by outperforming the index over many years.  However, during some years, they had “draw downs” that caused their funds to go negative.

Despite these “draw downs”, Buffett considers them to be the best investors in the world. Were they afraid of draw downs? No. Buffett has said that he and Munger have seen their portfolios drop by 40%, multiple times.

If you look at Charlie Munger’s performance in Buffett’s article, you will see that Munger had draw downs of -31.9% in 1973 and -31.5% in 1974. After those two years, his fund dropped by 53%. Most investors would panic and their hair would burst into flames if they experience this kind of draw down.

Despite this, Buffett considered Munger to be such a superior investor that he asked Munger to be his partner at Berkshire Hathaway.

This is because Buffett and Munger focus on Business Metrics, and less so on stock prices.

If you freak out over draw downs, you will lose money or be a mediocre investor.

You will also see that Munger’s fund was extremely volatile. As explained in my article Why Most funds Underperform, a Wall Street firm would not consider me because my portfolio was volatile. But, the less volatile your portfolio is, the less likely you will outperform.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.