I recently read a fascinating report entitled: “The secret that mutual fund companies don’t want you to know” that outlined some of the issues surrounding a statistic known as “drawdown”. Essentially, drawdown is a number that measures the percentage drop from a fund’s investment high to its investment low. The problem is that mutual fund companies tend to provide investors with calendar year figures, a somewhat arbitrary framework that can be a little bit misleading. When drawdowns are reported that way, it can be harder to get a truly accurate sense of how significant any losses in the funds may be—and to understand how long they take to recover.
While this article focused on mutual fund drawdowns, the same phenomenon is present with other investment vehicles. The S&P, for example, has had three drawdowns of more than 40% since the 1970s. For people nearing retirement to experience that type of a loss would be catastrophic. To put that in a more recent context, when we reached a new “high” this year for the S&P, what that really meant is that we had actually reached a break-even point (0% growth) since 2008.
For investors, that’s five and a half years of either losing money or climbing back to break even. Kind of takes the shine off of that record high, no? The article cites an example to show just how big the difference between projected and actual growth can be, and how the way that returns are reported can be misleading. Assuming a relatively conservative 8% growth rate, $100,000 invested in January of 2000 would have been projected to yield $466,000 two decades later. Fast forward to 2013, and you would have had to be at $282,000 to be on pace.
The reality, however, is that if you invested that in the S&P 500, you’d be only halfway to where you needed to be: $141,000. Far from 8%, your return would be a less-than-inspiring 2.58%. The lesson here? Avoid the drawdown trap by staying informed and tracking the bigger picture. Have “bumpers” on your car to protect yourself from these losses. Make sure that, whenever possible, you have a built-in mechanism to protect yourself. Diversification can help, but that won’t take all the risk out of it; take a look at riders on annuity contracts or other sources of guaranteed income to safeguard against sustained market slumps.