A Reader Questions: Do You Have A Maximum Price Drawdown You Will Absorb?

by: Peter F. Way, CFA

Summary

How big a loss should an investor tolerate?

Is there any way to forecast that it will happen?

What to do when/if it does?

Here is our response

Lew,

Thank you for your interest, and for the very reasonable question.

We recognize that there are dimensions to investing that really need to be maintained on a personal level; risk acceptance is a key one.

In order to provide a history of how well our Market-Maker [MM] price-range forecast information works in an unchanging TERMD portfolio management discipline, some bound must be put on the risk issue. Rather than make that limit one of degree of severity, we have chosen to use holding period patience instead.

Time has such an important function in building wealth that we believe time is the better invariable limit than a prescription of how much pain of the moment one can or should take before giving up on a position that is not now working out. Stocks have a way of marching to their own field commander.

This way combines a history of standardized behavior measuring how well prior forecasts at today's level have recovered (the Win Odds) from the worst price drawdown exposures experienced, along with the % Payoffs TERMD actually accomplished in this security at this level of MM upside-to-downside possible price-change forecasts.

With the recovery ratio -- often 6 or 7 out of 8 (75-87 of 100) -- and the payoff average -- frequently +10% or more, net of losses -- one has a risk~reward tradeoff which allows direct comparisons among alternative investment candidates at the same time, while letting the investor set his/her own limits of what odds they are willing to undertake, and what payoffs are large enough to make the gamble worthwhile.

Many find this approach way too complicated for what they take (too casually, in our opinion) to be a simple decision matter of "do we (as an investor) like this stock or not" and then go on to apply their same decision process to stock after stock.

For us that approach loses the essential discipline of comparing alternatives on an equal footing. With so many diverse variables for consideration, we believe it is enormously helpful to let the MMs and their well-resourced world-wide organizations distill the decisions down to price alone, and what may be expected to be coming in that department.

Price change is, after all, how the score is kept, and may be more important to wealth-builders than the "entertainment and romance" of contemplating many less well understood minutiae of financial fundamentals, competitive and technological advances, and market responses to them, one stock at a time.

Sorry to provide such a long-winded answer. I hope it makes the short answer easier to relate to your particular set of preferences.

Short answer: Please use the Win Odds and the % Payoffs as your tradeoff, with the Worst-case Price Drawdowns as a prior-to-commitment alert to the discomforts likely to be encountered. If you find, before making a commitment, any of these three things are outside of your comfort level, then seek some other choice(s) of the many alternatives always present.

More simply perhaps in an after the commitment situation: hang on to a troubled stock until its time investment proves out whether it is going to recover and become profitable. Minimize the potential of a devastating single loss by making each capital commitment decision limited to a very small part (1% or less) of the portfolio, and let each specific stock's investment build up through repeated commitments if and when warranted in competition with other alternatives. Put some size limit of your choice in a stock's accumulation, like 5% (but your choice), of the portfolio value.

Those commitments will each have their own price sell-targets and commitment-date originating time limits under the TERMD discipline. That will help ensure some beneficial presence when the price recovery actually comes, instead of the typical "three days after I have thrown in the towel and taken this awful loss on the whole position."

Wallet Kelly, -- as he sometimes referred to himself -- creator of the comic strip "POGO" observed so insight-fully, "we have met the enemy, and he is us." Our hope is to provide here one means to improve on those skirmishes.

Lew, thanks again for letting me explain why we do what we do, and why we think others should consider it. I do hope it acts as encouragement, and you will join the growing family of our enthusiastic subscribers.

My best regards,

Peter

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.