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The Maximum Drawdown Duration of the S&P 500 Is Infinite?
How to Determine the Liquidity Quality of Investments in Meaningful Terms
Liquidity is a poorly understood characteristic of investments. Most commonly, financial professionals think of liquidity simply in terms of how quickly an asset can be sold, regardless of the price. This consideration alone is not helpful.
People invest to grow their money, not to lose it. Return at the time of liquidation matters, and a lot. So, instead of looking at liquidity from the perspective of how quickly an asset can be sold, we should look at look at liquidity in terms of how much time is required to achieve the expectations of a given investment.
Maximum drawdown duration (at least a variation thereof) tells us what we need to know…
Maximum drawdown is the measure of the greatest loss peak-to-trough experienced by an asset or portfolio. Maximum drawdown duration, or MDDD, is the greatest amount of time elapsed between any peak and the next point exceeding that peak regardless of the degree of the drawdown in between, in other words, the longest time period ever required to recover losses regardless of the magnitude of the losses.
The traditional definition of MDDD, however, is insufficient. The time required to get back to zero is not helpful. If a return to zero was sufficient, the investor would simply hold cash avoiding additional risk.
It’s important to know how much time is required to recover losses plus accrued expected return, or MDDDs. The difference between traditional MDDD and MDDDs can be substantial. Here we see the S&P 500’s monthly performance across a timeframe of 37 years (January1985 - December 2022):
Expected return (blue curve) is 8.41%.
Traditional MDDD (yellow line) is 6 years 9 months (July 2000 - April 2007).
MDDDs (red curve) diverges. Since the March 2000 peak, we’ve been waiting to achieve the expected return for over 22 years and still counting. The expected return of the S&P 500 since the March 2000 peak is only 4.21%, which has an MDDDs of 20 years 6 months (March 2000 - July 2020, not illustrated). In other words, the appropriate time horizon for investors to achieve an 8.41% return in the S&P 500 is infinite, while the appropriate time horizon to achieve 4.21% is 20 years 6 months.
Why is this relevant to you?
Regardless of your preferred asset class, the S&P 500 is viewed as the de facto reference for opportunity cost by financial services.
To raise capital for your asset management business at scale, you have to think and operate like a sophisticated financial institution, and that starts with knowing exactly what you’re competing against.
The Shadow Banker’s Secrets: Investment Banking for Alternatives provides you the power of the world’s most sophisticaed asset management firms (e.g., Blackstone) to generate above-market investment returns while protecting your portfolio from market crises and scale past $1 billion AUM…
Read The Shadow Banker’s Secrets, then schedule your free private consultation.