Most Popular ArticlesJune 30, 2009
Market exposure risks
Full market exposure is risky – even during bull markets – because it increases the risk of drawdown. There is a material difference between actual loss and drawdown. Actual loss is painful but the healing process begins as soon as the investor realizes the loss. Drawdown, on the other hand, is like an open wound. It represents the pain of holding stocks when the markets turn against us. The pain continues to grow with every additional price decline. Exposure to uncertain and unfriendly markets is more harmful to investors’ mental health than actual loss is to their wallets.
Both the duration and the magnitude of drawdown for the two MAC systems are shown in Figure 2. The blue stripes are the 6-month MAC and the green are the 23-month. The average drawdowns for the two systems are 2 and 4 percent, respectively. Drawdowns of greater than ten percent were rare during the 138-year period. In comparison, the average drawdown of the buy-and-hold system was a painful 26 percent.
Figure 2 shows that the MAC system would never expose investors to an unfriendly market for more than a few months at a time. On the contrary, buy-and-holders could be underwater for over ten or even twenty-five years before breakeven, as shown in Figure 5 in my “Missing out” article. The mental anguish of suffering in a hostile market environment for such a prolonged period of time is unimaginable.
Active investments offer much lower market exposure risks than the buy-and-hold approach, both in magnitude and in duration of drawdown. Which camp would you rather join?
Annual performance tradeoffs
Markowitz’s Efficient Frontier is an instructive way to compare monthly performance because it shows risk-reward tradeoffs on a single diagram. Figure 3 shows annualized monthly returns (reward) versus standard deviations of annualized monthly returns (risk). To keep the graph legible, I show only the 6-month MAC (green squares) against the buy-and-hold (red squares) benchmark.
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