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When things go against you – handling drawdown

Research shows that the average down market lasts three to four months. However, it is not the short-lived down market periods that active investors should worry about, but the occasional longer and sustained down market periods, such as the one we are now experiencing. All ‘long’ strategies, whether they are Buy & Hold or more active, will go into drawdown during sustained bear market periods. The perennial active and passive investment dilemma is that nobody really knows when the prolonged bear period will occur or how long it will last. However most investors live in fear of such a situation and it is this fear that causes investors to become inconsistent in their actions during the down period and the ensuing positive market periods.

Why is there fear of such market periods? Because people fear losing. Is it a comfortable feeling living in fear of such market periods? Probably not. Would investment life be more liberating if such fears could be overcome? Probably so.

So how can we overcome the fear of losing? If this fear can be mastered, active investment will become much simpler and more enjoyable.

Most try to handle it by looking for a reason for their loss, hence analysing charts and indicators. However there will always be loss trades. So fear is impossible to analyse away unless a perfect solution can be found in which there is never any loss or drawdown. Such analysis is an infinite task that has a limitless path. If it is impossible to achieve a lossless environment through analysis in order to overcome the fear of loss, then another way has to be found to overcome the fear.

You can achieve this by changing the way you think about the market, by learning to think from the market’s perspective as we have said before. Why do we need to think from the market’s perspective? Because understanding why and how the market moves makes us empathetic with the market, we become one with the market’s movements, we become an insider looking out rather than being an outsider looking in. Markets do move up and down, not just up. An obvious statement we could assume. So why do people have an eternal expectation of upward movement only and become despondent when downward price movement prevails?

Another way to think about the market is to accept that down periods are good for the market because they allow the market to catch its breath. Down periods provide the setup for new upward moves. Up periods, which bring profits, follow down periods. This is the law of polarity—everything has an equal but opposite polarity: there are ups and there are downs, there is hot and there is cold, there is good and there is bad, there is outside and there is inside, there is long and there is short, hate and love, pain and pleasure, win and loss, bitter and sweet, good shots and bad shots, etc. As an imperfect growing human being, in every endeavour we will experience positive and negative outcomes. This is the law of polarity.

In the context of the market down periods causes drawdown in portfolios and generate loss trades. All of these movements are a necessary part of the anatomy of the market. We must encourage ourselves to accept down markets rather than feel fear, despair, frustration and anger. We must learn to accept drawdown in our portfolios as a necessary occurrence of active investment. Whilst still tough, this is easier when using a proven system with a positive expectancy.


  • Rod R. says:

    Hi Gary,

    You mentioned the average down market lasts three to four months. I recently came across some info that said in the US 69% of market corrections happen between 1 and 2 months in duration. Given that our market is very closely correlated to the US (particularly in periods of uncertainty) I am surprised that the average down turn in Australia is 3 to 4 months. Can you shead some more light on the subject?



  • Gary Stone says:

    Response to Comment by Rod:

    I would be interested in how the stats were measured for the comment “69% of market corrections happen between 1 and 2 months in duration.” Does this mean the averaging calculation excludes the other 31% of corrrections?

    Also, the 1 to 2 months may refer to the correction and not the runup. In our research we have measured the length of the correction (down leg) and the runup (up leg) to where the market makes a new high. If the length for the correction is roughly the same as the runup then the stat is not that different.

    All in all it doesn’t really matter how long a correction is as I don’t believe that this data has any predictive value that could be profited from. We must treat each market correction and runup on its own individual merits.


  • Geoff Gray says:

    Dear Gary
    I read your words with complete agreement and wonder at times, how do I get on the right side of the cycle and can you be too clever ie not obey your instincts that the profit should taken because the “bubble ” must collapse, the energy can only rise so much and the fall is just as great. Confidence is everything as well as the style of trading you employ.
    Analysis is good if as you say accept losses as a way of learning but how we buy without some latitude so disappointment does not occur. Should we buy at market or fiddle with a few cents. What is the big picture that we keep forgetting – you can not play unless you have the stock and a clear idea on what your goal is. When I lose that, I lose by doing silly things.
    Your attitude towards having the right pysche is true but how to have that correctly aligned is my problem. Life has its pull on you regardless so just perhaps a routine is needed, some mantras, some warming up exercises and empathy with similar minded.
    Should it be a way of life?
    Your thoughts would be appreciated.

  • Gary Stone says:

    Response to Comments by Geoff:

    “…can you be too clever ie not obey your instincts that the profit should taken because the “bubble ” must collapse, the energy can only rise so much and the fall is just as great.”

    This can be a huge subject and can have a lot to do with using ones intuition. The problem is that sometimes your intuition will be right (on the basis that it will not be wrong EVERY time you use it) and this can allow us to justify using it more often. The real question to answer is whether your intuition has a better edge than using a system with an edge – which, by definition, will be known. Easier to ask the question than to answer it as a system’s performance is very measureable whereas measuring ones intuition is very difficult and the odds are that one would bias outcomes towards it being more right than it actually is. One way to measure ones intuiton is to put aside some money and trade it as you see it, using nothing but your feeling about what actions to take in the market.

    Ultimately, a good intuitive trader will do far better than a good mechanical trader. The issue is how poorly each do on the way to becoming good at what they do, if in fact they even get there assuming that they each start mechanically and intuitively and remain on that path.

    My personal view is that mechanical (like we all learnt to ride a bike or drive a car) is the best way to learn and slowly to allow ones intuition to come into play over the years (not months or weeks!). When to do so and when not to is a feel thing. One has to learn to become consciously aware of ones feelings and to ‘instinctively’ know when to trust their intuition and when not to. It is not something that one can think about because if one does, by definition, it is not intuition as the logical, reasoning mind is in control and when it is, intuition isn’t.

    “Should we buy at market or fiddle with a few cents.”

    A trader should only buy At Market if the entire order can be filled at the current ask price. Depending on the liquidity of the market being traded, it is usually better to place At Limit orders but not to let them sit for too long (choose a specific time) or the market could run away from you. Define some specific rules about placing orders and then be consitent in following them.

    “… just perhaps a routine is needed, some mantras, some warming up exercises and empathy with similar minded.
    Should it be a way of life?”

    A routine is absolutely needed. The less consistent (I was going to write experienced but there MAY be no correleation between experience and consistency) one is, the greater the need for routine and process. The more defined the process the better. This is all part of a transition process that I have described in a chapter of a book that is due out soon called “The Wiley Trading Guide”. Keep an eye out for it.

    I trust that this helps.


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