Long read: Drawdowns and Recoveries: Base Rates for Bottoms and Bounces

Barring the last September to February of this year’s pull back in Indian markets we saw, an overwhelming majority of today’s Indian retail investors (directly in stocks or through mutual funds) haven’t experienced a proper drawdown (deep and prolonged). For the uninitiated, a drawdown is the price decline from peak to trough. Yet, as they say, drawdowns are a feature of the stock market not a bug. Here’s Michael Mauboussin and his colleague, armed with lots of historical data about drawdowns and the ensuing recoveries helping us understand the opportunities and challenges in long term investing. He begins with the great Charlie Munger’s quote:

“I think it’s in the nature of long-term shareholding with the normal vicissitudes in worldly outcomes and in markets that the long-term holder has his quoted value of his stock go down by say 50 percent. In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50 percent 2 or 3 times a century, you’re not fit to be a common shareholder and you deserve the mediocre result you are going to get—compared to the people who do have the temperament who can be more philosophical about these market fluctuations.”

He goes on to add: “The partnership that Munger managed produced a compound annual growth rate of 19.8 percent from 1962 to 1975, but it suffered a 53.4 percent drawdown in the 2 years ended in 1974.”

The report is rich with startling pieces of data and fascinating takeaways. We highlight some of the findings here but recommend going through the report in detail:

“The median drawdown for the 6,500 stocks in our sample from 1985-2024 was 85 percent and took 2.5 years from peak to trough. More than one-half of all stocks never recover to their prior highs.

Relative to smaller drawdowns, larger drawdowns, on average, take longer to occur, recover to the previous peak less often, and yet can provide attractive returns off the lows. Recoveries from drawdowns of all sizes have significant skewness, which means some stocks do extremely well relative to the pack. As a result, average returns from rebounds are higher than median returns.”

This one’s our favourite: “An investor who had the perfect foresight to create a portfolio of the stocks with the highest returns in the next five years would still see substantial drawdowns along the way. Indeed, one five-year stretch of the foresight portfolio had a 76 percent drawdown. This underscores how hard it is for professionals to manage through drawdowns.”

For those who thought a diversified mutual fund helps avoid this: “Mutual fund results follow a similar pattern. While the absolute levels of drawdowns were less than those of individual stocks, the average drawdown for the top 20 funds for the 25 years through 2024 was 60 percent. These funds subsequently produced substantial excess returns”

And then the best part: what works as a statistic at a population level may not work anecdotally. Case in point is this century’s best performing stock and the world’s largest company by market cap today- Nvidia.

“NVIDIA did an initial public offering (IPO) in January 1999 and has been one of the best stocks in the market since that time. In the 20 years ended in 2024, the compound annual return for NVIDIA’s stock was 39 percent, making it the leader among all stocks in the S&P 500.

The ride from the IPO to the present has not been all smooth. From January 4, 2002 to October 8, 2002, NVIDIA’s stock dropped 90 percent. This maximum drawdown was larger than the median of 85 percent for all U.S. stocks and happened in 0.8 years versus a median of 2.5 years for the complete sample.

This precipitous drop was at the tail end of the dot-com bust. Over the same period, the PHLX Semiconductor Sector Index (SOX), an index of the 30 largest U.S. stocks involved in the semiconductor industry, fell 65 percent.

It took 4.1 years, from October 2002 to November 2006, for NVIDIA’s stock price to regain its prior peak after hitting bottom. The median time back to par for all companies is 2.5 years. NVIDIA shares fell more quickly and recovered more slowly than the median stock within the S&P.”

Nvidia challenges the belief that stocks that perform well in the long run tend to have lower drawdowns and are quick to recover.

Finally, he shares data showing mean reversion where stocks that go through the sharpest drawdowns on an average tend to give the best returns on the bounce. Whilst this might tempt many of us to go bottom fishing, Mauboussin provides a helpful guide on what to look for:

“Trying to pick a bottom is a fool’s errand. But we offer some qualitative considerations for whether it makes sense to play a rebound. These include an assessment of whether cyclical or secular factors induced the drawdown, whether the basic unit of analysis is viable, how lumpy investments are, the financial strength and staying power of the company, whether there is access to capital if need be, and whether management is dealing with the challenges head-on.”

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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.