How to deal with Drawdowns on Systems and Managed Accounts

Drawdowns as defined by Investopedia are the peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the trough.

However what I wanted to address is why drawdowns occur and how they affect traders and investors psychologically.

First of all, regardless of the performance of an investment whether a mutual fund, stock, managed futures account or the track record of a system whether real or hypothetical - all investments go through periods of drawdowns.

In the case of futures - where a system or a CTA makes trading decisions to go long or short - it requires further explanation.

Here are 2 main reasons for it:

1)     Systems can have several indicators that perform well during a particular trading environment (such as trend-following vs. volatility based) and under-perform in a different environment. Typically, trend following systems fail during high volatility and will resume their up trends as volatility subsides while volatility based methodologies may under-perform during choppy periods.

2)     No single indicator is perfect. Most indicators are known as lagging indicators (rather than predictive), so before positions turn profitable, often one’s portfolio will be in the red before it eventually goes in the black.

Drawdowns are a backward looking statistics. Therefore, they cannot tell us with accuracy what will happen in the future. However, they are a good way to compare investments and can give us an idea as to what to expect.

You have to examine two factors, the length of the drawdown and the time to recovery.

Good systems and good managers will recover from drawdowns but investors also have to determine ahead of time what their risk tolerance is in the face of adversity.

Past performance is not indicative of future results.  There is a risk of loss in futures trading.

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