Drawdowns: “Active” versus “Passive”

December 13, 2016, was a historic day.

The Nasdaq 100 (QQQ) closed above $120 for the first time in almost 17 years!

That’s right… anyone who bought the Nasdaq in early 2000, just before the March 24 peak, has been suffering through a 17-year-long drawdown.

Can you imagine waiting that long just to get your money back? Never mind actually making a profit!

I know… I know… you’ve had “buy and hold” preached at you for all of your investing career. You’ve been told the “hold” part is psychologically difficult, but ultimately worth it in the end.

But is it really worth it?

Or, is there a better way through “active” investing?

We’ll answer that question today.

Before we do that, realize that drawdowns are a simple fact of life in investing. Sometimes they’re small and short. Sometimes they’re large and long.

You can work to minimize drawdowns (that’s risk management). But you can’t eliminate them.

So what does the typical drawdown – for both “buy and hold” and “active” strategies – look like?

Look at this chart from Ben Carlson’s blog, A Wealth of Common Sense.

He crunched the numbers and determined that the S&P 500 spends…

  • 13% of its time in a 5% to 10% drawdown,
  • 13% of its time in a 10% to 20% drawdown, and
  • 23% of its time in a drawdown greater than 20%

The S&P 500 has been in drawdown more than 70% of the time, since 1927!

And at least half the time, buy-and-hold portfolios were in a drawdown of 5% or more.

Since most investors panic-sell during drawdowns – particularly those bigger than 20% – it’s easy to see why the “hold” part of buy-and-hold is so difficult (psychologically) and damaging (economically).

This situation is not unique to the S&P 500. It’s the typical state of all equity markets, across all time periods: most of the time in drawdown; occasionally making new highs.

But it’s been even worse than that for the tech-heavy Nasdaq 100 ever since the turnrn of the century. I ran those numbers myself, by analyzing the drawdowns of the PowerShares Nasdaq 100 ETF (Nasdaq: QQQ).

Since 1999, the Nasdaq has spent a full 98% of its time in drawdown!

84% of the time, it’s been in a 20%-plus drawdown.

It’s minted new all-time highs just 2% of the time.

That’s rough!

Show me a human investor and I’ll show you an investor who likely gave up and sold out somewhere along that 17-year journrney of drawdown agony! (Did you?)

Active investing is often painted as being riskier than passive, buy-and-hold investing. But nothing is further from the truth – particularly when it comes to the risk of abandoning your strategy during a psychologically-trying drawdown.

As I’ve said, you can’t eliminate drawdowns, but you can minimize them. That’s called risk management, and it’s exactly what active strategies, like Cycle 9 Alert, are designed to do.

To prove it, I applied my Cycle 9 Alert algorithm to all 100 individual stocks in the Nasdaq 100 – going back to the same starting point of 1999. And then I’ve compared the performance of my active strategy to the performance of buy-and-hold. Take a look at the results…

As you can see, not only would the active Cycle 9 strategy have produced more total profits over the entire period, it would have done so with milder drawdownsquicker recoveries… and many more “new all-time highs.”

Take a look at this table, which summarizes the amount of time spent in each drawdown category…

All told, my message today is simple.

You must get used to the psychological rub of drawdowns. But you do not have to accept the large-and-long drawdowns inherent in buy-and-hold.

Active strategies, like Cycle 9 Alert, work to minimize drawdowns – both their degree of severity and their duration.

I’m sure you’ll agree with me… living through mild drawdowns is easier than large drawdowns. And making new all-time highs often is easier than waiting year after year to simply get your money back.

To the extent that active strategies minimize drawdowns, they help investors stick to the strategy – which is the key to profitability in the long run.

So the next time you hear someone tell you that passive investing is safer than active investing… set them straight!

And if you’re not already benefitting from the drawdown-reducing feature of active strategies, now is a great time to take a look at my Cycle 9 Alert service.





Adam O’Dell

Editor, Cycle 9 Alert

Follow me on Twitter @InvestWithAdam

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Adam O’Dell

Using his perfect blend of technical and fundamental analysis, Adam uncovers investment opportunities that return the maximum profit with minimum risk.