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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Dual Momentum: Why It Beats the Index

Since 1970, when International equity data became widely available thanks to the MSCI EAFE index, a portfolio invested in Dual Momentum would have substantially outperformed its individual components.

Dual Momentum has outperformed the U.S. stock index by about 6% per year; it outperformed International stocks by around 7% per year; and it outperformed bonds by nearly 10% per year.

Dual Momentum would have outperformed a buy-and-hold indexing portfolio of these three components, equally weighted and re-balanced annually, by roughly 7% per year. With a lot less volatility and lower drawdowns.

Picking the Right Investment at the Right Time

The reason Dual Momentum has stellar performance, beating its own components, with minimal drawdowns is because it (in a rough sense) picks the right asset to be invested in at the right time.

When U.S. stocks are beating International stocks and bonds, Dual Momentum will often have you entirely invested in U.S. stocks. We saw this happen in the period of 1995 through 1999 where Dual Momentum would have you invested in U.S. stocks in all but three months during this time.

Likewise, in the period of 2003 through 2007, when the investment world was buzzing around resources, peak oil, copper booms, the BRICs, and European property prices, Dual Momentum would have your entire portfolio invested in International stocks.

You would also been invested entirely in International stocks in the late 1970s and in the mid 1980s.

Just as importantly, Dual Momentum helps you avoid the worst of those long downturns in equity markets. You would have moved to bonds in at the end of 1973 and until early 1975, again in 1981-1982, also for the bulk of the 2000-2003 crash, and finally in 2008-2009.

Achieving positive returns in your portfolio while equity markets are getting slammed is a huge advantage!

The biggest drawdowns in Dual Momentum occurred during the 1973-1974 correction and the 2008-2009 market crash. In both of these huge events, your total drawdown would have been around 20%. (The true drawdown is just a best estimate as bond return data is hard to obtain for the 1970s.)

Don't forget that U.S. stocks and International stocks dropped well over 40% during these market events, sucking down buy-and-hold index portfolios with them.

Over the course of an entire bear market, Dual Momentum handily beats a buy-and-hold approach. In nearly every bear market event, Dual Momentum portfolios would have smaller and shorter drawdowns compared to a passive buy-and-hold index portfolio.

To get a visual of how Dual Momentum performs compared to an annually re-balanced equal weight portfolio, here's a logarithmic chart for the backtest period.

Sources: See Portfolios page

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.