The psychology of drawdowns

How do investors measure unrealised losses?

One way is to compare the current price with the price paid for an investment. So, for example, if you pay 100 for an investment and its current market price is 90, then you are sitting on a (unrealised) loss of 10%.

But if, after buying the investment at 100, the price had risen to 120 before then falling back to 90, then there is the temptation to anchor the price at 120 and regard the current price of 90 as a 25% loss.

This 25% loss is referred to as the drawdown, which is defined as the percentage loss from a previous peak. The concept is common in trading but can also be useful for investors to understand.

The following table shows the drawdowns for the FTSE All-Share Index for the period 1969-2017.

FTSE All-Share Drawdowns [1969-2017]

The first thing to notice about the chart is that there are an awful lot of drawdowns! In fact, because the market doesn’t make new highs every day it is usually in a drawdown state. And this can have a psychological effect on investors.

If you look at a typical long-term chart of the stock market, and many individual shares, you will usually see a line that starts at the bottom left and increases (moderately steadily) to the top right.

This is a Good Thing – stocks go up in the long-term!

However, that chart does not necessarily reflect the actual experience of being invested in the market over this period. For this, the drawdown chart above may more accurately represent the feelings of investors. This is because investors’ portfolios are underwater for most of the time, i.e. the portfolio value is below its peak value (which will most likely be a recent strong memory for the investor).

The table below breaks down how long the market spends at various drawdown levels. For example, for 16% of the time from 1969 the market had a drawdown of 5%-10%, and it was in a drawdown state of over 20% for 27% of the time. And, while a drawdown of just up to 5% may not seem very much, in practice it is 32% of the time that investors are likely to be feeling slightly disgruntled having “lost” money.

FTSE All-Share Drawdowns [1969-2017] 02

So, while the data shows us that stock markets increase over the long-term, the direct personal experience of investing may be for investors largely that of a prevailing sense of loss. This sense of loss is something that investors have to learn to live with.

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