![]() ![]() ![]() The shorter time frame usually creates greater emphasis on capital preservation. Our investment experience has found that most individual investors are emotional and tend to react to losses and gains differently. Using these downside risk metrics, you can make a more informed decision in terms of diversifying a percentage of your portfolio to high yield as an equity substitute. This also holds true over the last 10, 15, and 20-year periods. In the chart below we have input the returns, Max Drawdown, and Downside Deviation for the S&P 500 Total Return ETF (SPY) and the Merrill Lynch High Yield Master II Index (MLHY).Īs you can see above, through 2011 the high yield asset class has outperformed the equity market over the last 1, 3, and 5 years with a lower Max Drawdown and lower Downside Deviation. Managers with longer histories will generally have larger Max Drawdowns.Max Drawdown alone does not take into account the time to recover.Max Drawdown is only a one-time measure, and has little value in analyzing the possibility of future occurrences.Max Drawdown lets you know how bad the worst was in a given period.Max Drawdown measures the amount you would have lost at a given point in time, and allows you to determine if you are comfortable with that loss in comparison to the return.Max Drawdown is simple and easy to calculate allowing an investor to easily understand the meaning of the calculation.The calculation and understanding of the calculated number are more complexĭefinition: Max Drawdown is defined as the "Percentage loss that an investment incurs from its peak value to its lowest value in a given period."įigure 2: Max Drawdown of SPY (S&P 500 ETF) in 2011.For example, you could set the Minimum Acceptable Rate at "0" if you only want to measure the times when the returns falls below 0, or have the Minimum Acceptable Rate change to match a "risk-free" asset (i.e. Downside Deviation allows flexibility: you can change the Minimum Acceptable Rate depending on the desired risk parameters.Downside Deviation uses historical data to provide a glimpse at the likelihood and possible ranges of return when an investment under-performs.Downside Deviation isolates the negative portion of the volatility (below the red line in the chart example) to ensure that volatility to the upside does not penalize the manager/security.1 deviation encompasses 67% of the downside return occurrences 2 deviations encompass 95% of the downside return occurrences and 3 deviations encompass 99% of the downside return occurrences. After all, why should we penalize a manager for "good volatility" or upside, when an investor really only cares about his/her account loss?ĭefinition: Downside Deviation measures the price volatility of a security, but unlike Standard Deviation, Downside Deviation isolates the downside movement by only calculating the times when the price falls below a defined Minimum Acceptable Return. These risk metrics isolate downside risk parameters more precisely by measuring the downside volatility (risk) of a security or fund. However, two NOT so common risk metrics are often overlooked: Downside Deviation and Maximum Drawdown. These metrics provide a useful insight into a portfolio's risk and return characteristics and play an important role in understanding how different performance patterns impact risk-adjusted results. ![]() There are many common risk metrics for identifying superior risk-adjusted returns: Standard Deviation, Beta, Sharpe Ratio and Tracking Error to name a few. However, some of us choose to invest our monies in the security that nets the lesser return because it is considered "less risky." But how is "less risky" defined? What is the downside to each respective investment or asset class, and how can it be measured statistically to evaluate risk-adjusted opportunities?Īfter the global stock market declines of 2000 to 2002, 2008, and again in 2011, investors and advisors are re-thinking the way they define risk. All things equal, most investors would rather invest in a security (ETF, Stock, or Fund) up 15% versus another security up 10%. ![]()
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