Dual Momentum: Analyzing the Drawdowns

As a self-directed investor choosing their own investment strategy, it can be way to easy to get caught looking only at the upside. The compounded annual returns.

But before adopting any investment strategy, it is even more important to look at the drawdowns. If you can't handle the drawdowns of your chosen strategy, you won't stick to your strategy.

Worse, you are likely to abandon the strategy at the worst possible times.

If you understand the characteristics of the drawdowns in your chosen investment strategy, you have a huge advantage over other self-directed investors (who demonstrably have horrible long-term returns). Discover the frequency of the drawdowns, the process is behind them, the severity, and the recoveries. Then expect your real world results to be at least 25% worse than the past at some point in the future.

What are Drawdowns?

As an investor, it is important to know what drawdowns are because your portfolio is actually in some form of drawdown the vast majority of the time.

A drawdown is any time that your portfolio is not at a new high value. It could be down from the peak value by 0.001% or by 100%. Thankfully most drawdowns are barely noticeable, and that's a good thing!

To get a better grasp on understanding portfolio drawdowns, you need to grasp the importance of variations on timing periods.

If you look at your portfolio every minute, you will find your investment account to be in a drawdown like 99.9% of the time.

If you are a bit more trusting of the process and can restrict your portfolio peeks to just once a week, you will probably be in drawdown around 80% of the time or more.

However, once you stretch that out to looking just once a month, you are actually going to be at a new high a whopping 30% of the time! (That's using US Total Stock Market data going back to 1993.)

It's hard to believe, but even if you are completely apathetic to your investment portfolio and look at your portfolio once a year only, if you are a buy-and-hold index (60/40) investor you will likely see your portfolio in a drawdown at year-end almost one-quarter of the time.

Being in a drawdown is not the same as having a negative return for a specific period. If there is a large negative return in one period, you could find yourself in a drawdown for a long time, despite multiple periods of positive returns within that drawdown.

Dual Momentum Drawdowns

First, it is important to understand that Dual Momentum is far from Drawdown-Free.

On a monthly basis, since 1970, an investor in Averaged 6 & 12 Month Dual Momentum would have been in a drawdown 57% of the time.

On an annual basis in the same time period, an Averaged 6 & 12 Month Dual Momentum would have been in a drawdown almost 20% of the time looking at year-end results only.

Let's take a look at every portfolio correction (drawdown exceeding 10%) that an investor in this Dual Momentum program would have experienced since 1970.

Source: TheRichMoose.com

1. May 1971 - January 1972

Peak to Trough Length:  6 months
Max Drawdown:  -12.04%
Recovery Time:  2 months
Total Drawdown Period:  8 months

2. April 1973 - December 1976

Peak to Trough Length:  30 months
Max Drawdown:  -22.46%
Recovery Length:  14 months
Total Drawdown Period:  44 months

3. April 1984 - October 1984

Peak to Trough Length:  2 months
Max Drawdown:  -11.59%
Recovery Length:  5 months
Total Drawdown Period:  7 months

4. September 1987 - March 1988

Peak to Trough Length:  2 months
Max Drawdown:  -15.33%
Recovery Length:  5 months
Total Drawdown Period:  7 months

5. July 1998 - January 1999

Peak to Trough Length:  2 months
Max Drawdown:  -14.74%
Recovery Length:  5 months
Total Drawdown Period:  7 months

6. April 2000 - September 2001

Peak to Trough Length:  6 months
Max Drawdown:  -11.47%
Recovery Length:  12 months
Total Drawdown Period:  18 months

7. November 2001 - December 2002

Peak to Trough Length:  6 months
Max Drawdown:  -10.26%
Recovery Length:  8 months
Total Drawdown Period:  14 months

8. November 2007 - March 2010

Peak to Trough Length:  7 months
Max Drawdown:  -18.59%
Recovery Length:  22 months
Total Drawdown Period:  29 months

9. April 2010 - October 2010

Peak to Trough Length:  3 months
Max Drawdown:  -13.66%
Recovery Length:  4 months
Total Drawdown Period:  7 months

10. May 2011 - January 2013

Peak to Trough Length:  7 months
Max Drawdown:  -16.75%
Recovery Length:  14 months
Total Drawdown Period:  21 months

Drawdown Summary

In the past nearly 50 years, Dual Momentum experienced a portfolio correction approximately twice each decade.

Half of the corrections were relatively quick and painless (less than one year in duration and/or less than six months for recovery from the bottom) considering the sometimes extremely nasty broader investing world.

Interestingly, many of the correction periods came in bunches. The July 1998 to September 2002 and November 2007 to January 2013 periods could test the patience of the best investors.

Before pursuing any investment strategy, take a deep dive into the negative periods! Dual Momentum is pronounced a failed strategy every few years without fail. But a steadfast Dual Momentum investor who understood the reasons behind the periods of poor performance and the outcomes following those performance periods would have significantly outperformed the quick-to-criticize buy-and-hold indexing crowd.

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5 Replies to “Dual Momentum: Analyzing the Drawdowns”

  1. Jonathan D. says: Reply

    Hi Daren!

    I’m also on the quest of early retirement (my goal is to be FI in the next 5 to 8 years). I found youe blog 2 days ago and I spent almost all my free time on it ;).

    Q1: Did you make any backtesting on a leveraged dual momentum portfolio?

    As I said my FI goal are somewhat flexible and I plan working part time for a good amount of years after that, so the amount of risk I can manage is pretty high (29yo). What kind of return a leveraged dual momentum with the same kind of drawback of a non-leveraged buy&hold portfolio would have? And is it worth it?

    Q2: If you have the cashflow to cover a margin call, what’s the difference between using leverage in real estate vs the market?

    Thanks for your time.

    1. Daren (Editor) says:

      Thanks for reading!
      1. I have not done any backtests specifically on using leverage with a Dual Momentum portfolio. Don’t forget that leverage is a broad term. You can have daily leveraged ETFs from 1.25x to 3x. You can use margin to buy more of a regular ETF up to the minimum margin ratios. The effects of these will be a bit different. Also access to leveraged ETFs is better on U.S. exchanges. As well, it doesn’t make sense to use margin to buy ETFs in a registered account as the interest rates are higher and they are not tax deductible.
      That said, if you have a specific example that you would like me to backtest let me know. I can do any backtests using a margin model. I can’t do daily leverage on International stocks because daily data is too difficult to obtain for the entire time period (from 1970).

      2. Real estate mortgages are secured loans against a (perceived) low risk asset that are never revoked during the term of the loan as long as you make payments. Also, you can get massive leverage (19:1) for personal homes. A big factor here is that house values are not updated every second of every trading day on an open market. If they were, I would suspect that home loans would look a lot more like margin loans.
      The biggest issue with margin loans are margin calls. Margin calls can result in automatic sales of your stocks, even if you are making the interest payments! It is very dangerous to push margin loans to the max for this reason. As everyone says, use margin very cautiously. This usually means 2:1 or thereabouts. The only way to get massive leverage is through derivatives like index futures markets.

  2. Jonathan D. says: Reply

    Thanks for your input on my interrogations.

    I was aware that a margin in a registered account makes no sense. My income is mostly from government grant (I’m the host family for people with intellectual disabilities) which don’t add any room to my RRSP & TFSA (but is also almost tax-free). So each year I soon need to rely on a non-registered account for all my savings, so a margin would make more sense than leveraged ETF.

    I would be really interested to see how different levels of leverage add to the peak drawdown and the compound annual returns. It seems to me that it could be a way to get the same level of risk as a balance buy&hold portfolio with an even better return than the vanilla DM. If you could backtest those models I would be really interested to see them. Also, what is your opinion on adding a little bit of leverage to the dual momentum strategy?

    1. Daren (Editor) says:

      Not a problem, I will do a post on introducing leverage into DM in the next month or so. It will take me a bit of time to run the backtests on Excel with the necessary adjustments. I am going on vacation, so I won’t be very active on the blog for the next few weeks.
      I think that DM is suitable to moderate use of leverage. Based on very rough backtests, the results when using 1.25:1 or even 1.5:1 looked quite promising. However, it occasionally bites the other way. One example of that was 1987 where a DM investor would have been fully invested.

  3. Jonathan D. says: Reply

    Great. Thanks Daren.

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