Wednesday, January 2, 2013

The Only Statistics That Matter

There are a bunch of statistics that Wall Street uses to try to help investors evaluate potential investments.  Most of these measures are useless or close to useless.  The two most important statistics that will help an investor determine whether they will be happy with a potential investment are Maximum Drawdown and MAR ratio.

Maximum Drawdown is the maximum peak to trough loss in an investment.  For example, let's say you put $100 into a mutual fund in January.  In August it is worth $200 and in December it is back down to $110.  The mutual fund company will tell you that you made 10%, and they would be right, but it probably won't feel that way.  Instead you may look at it differently thinking you had  $200 in August and $110 in December so you lost 45%.  This is the maximum drawdown.    Now you might be thinking---why do I care about Maximum Drawdown, I made 10% I would be happy with that?   That's fine, assuming you invested in January, but what if you invested $200 in August?  The mutual fund would be up 10% for the year but you would be down 45%.  Drawdowns occur in just about every investment, it is just a matter of when.    They don't matter as much if you have held the investment for a while and have large gains, but they matter a lot more if they happen when you start off in an investment.    Of course past returns don't predict future results but if an investment has had a 20% drawdown in the past it is likely that it would have another similar drawdown in the future.

Knowing Maximum Drawdown is half the battle,  any investment that has potential to appreciate will have a drawdown, so how much is acceptable?   Part of the answer to that depends on your risk tolerance and what the money is for but the main question you should have is are you being compensated for the risk you are taking?  This is where MAR ratio comes in.  MAR is the average annual return of an investment divided by Maximum drawdown.  When we evaluate investments or strategies we don't look at anything with a MAR under 1, and much prefer MARs approaching 2.   Using an S&P 500 Index ETF (SPDR S&P 500 symbol SPY) as an example, according to Morningstar the average annual return over the past 10 years is 7%, we also know that the S&P 500 had a drawdown of about 60% from October 2007 to March 2009, so the MAR for this fund would be .11 (7/60).  For us to consider an investment that had a 60% drawdown we would need an average annual return of at least 60%. 

Buy and hold stock based investments and investment strategies will always have large drawdowns as they do nothing to stem losses when the markets go down so it would be nearly impossible to find a buy and hold stock based strategy with a MAR ratio anywhere near 1.  Trend following and  other tactical strategies are the only way to find higher MAR ratios.  Trend following strategies will still have drawdowns, but they tend to exit markets before bad turns into really bad.

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