**A Deterministic Indicator of Real Risk**

June 24, 2018

Another deterministic indicators not based on the logic of mean and variance, is the "max drawdown" that is the maximum loss that a financial instrument has suffered in the past.

Let's start from how it is calculated, which is simple but it is necessary to understand well hot the indicator work: suppose that at time t1 the value of a fund is 100, at time t2 the value is 105, at time t3 the value returns to 101, the drawdown is equal to 4%, that is the difference between the maximum value of the time series and the minimum value following the maximum.

Of course, if the historical series then drops to 90, the max drawdown will be almost 15%.

BECAUSE IT IS IMPORTANT?

Because it highlights the maximum loss that a given financial instrument, even it’s a fund, a stock, a crypto-currency or a monetary instrument.

It is an indicator that highlights the true risk of loss that this instrument in the past has forced to bear all those investors who bought this instrument before the maximum.

As often said, volatility, often considered an indicator of risk (but in reality an indicator of uncertainty) is not able to describe well the real risk that an investor is having to bear.

These two historical series have the same mean and variance, but completely different path and therefore maximum loss that the client had to bear.

This chart below is well known by those who follow DIAMAN or our blog, and represents the recovery percentage needed to return to the initial value after a specific loss.

This relationship between loss and recovery, becomes more and more extensive as the loss becomes more relevant; to make an example, if I lose 25%, to return to the value of 100 I have to make 33,3%, or the ratio between 25% and 33% means that I need to use 133% more energy for recovery the loss.

If I lose 50%, to return to 100 I have to double 50, that means a performance of 100%, and the ratio between losses and gains is 200% , in other world, losses count double respect the gains.

If then the investment loses an additional 10 of value, going from 100 to 40, with a loss of 60% (instead of 50%), the necessary recovery is equal to 150%, so the ratio between losses and gains becomes 2.5.

EXPONENTIAL

From this it is clear that the more the loss is great, then is amplified the energy needed to recover the previous losses.

So it is essential to understand if the financial instrument that you want to buy, is able to protect from large losses or not, and this can be known only by analyzing the historical series not with the mean and variance but with an indicator of maximum drawdown.

DEFECT

The flaw of this indicator is that it measures only the worst case success in history, but other indicators will be analyzed in the coming weeks to solve this limit, but certainly it is a very valuable indicator to expect from that investment a potential future loss, and therefore to understand (also in view of MiFID II) if this loss can be tolerated or if it can lead to problems in the management of investments.

SOLUTION

To reduce the potential maximum loss there are three tools:

1) Dilution

2) Diversification

3) Active management

DILUTION

The dilution means that if I want to buy an American stock fund, but I'm scared to lose 50% of my wallet, and at most I can tolerate a loss of 12.5%, then I'll have to invest 25% in the American fund and 75% in assets without risk (or almost); MiFID II prefers this logic that, however, in my opinion presents many other risks, not least the fact that current low-risk assets, such us Govt. Bonds, represent a risk much higher than that revealed in past years, given that returns are practically zero and a possible increase in rates would reduce the prices.

DIVERSIFICATION

Diversification is fundamental in investments (Madoff teaches us this kind of risk with the mega USD 50 billion fraud); a healthy diversification is fundamental, so much so that we have developed indicators to try to understand when diversification is sufficient or poor. Clearly diversification does not dilute the systematic risk, but at least the specific yes.

With EXANTE Funds software, we have developed Stress Test Scenarios to understand how a particular investment portfolio would behave in certain past crisis situations, to allow the Asset Manager to understand if the diversification and the composition of the portfolio can reduce the maximum drawdown.

ACTIVE MANAGEMENT

The third practice to reduce the maximum drawdown is active management, so much criticized by those who do not have the right instruments to do it (it takes a wealth management to be efficient, otherwise it becomes almost impossible for a financial advisor to provide active management to its customers).

Actively managing entry and exit from the markets is something that DIAMAN has been running since 2002, in times when there was still no discussion about risk on and risk off (as this strategy is often called), few people really knew what quantitative strategy meant and above all the word “Robo Advisor” had not yet been coined.

Data source: Banca Patrimoni Sella and Diaman SCF, Elaboration: Diaman SCF

This chart shows the global stock market from July 2002 to. July 2017 (15 years) with a dilution solution (blue line, 50% -50% balanced benchmark) and real dynamic management (this is not a back test but official data of the bank responsible for asset management) that enters and exits weekly with protective strategy and non-speculative view.

NOT SIMPLE BUT POSSIBLE

Actively managing the entry and exit of a financial instrument is not objectively simple, it takes method and methodologies to do it, but honestly we can boast of having drastically reduced the maximum losses to customers (and consultants) who have believed in us in all these years, and I am reasonably confident that we will continue to perform it in the future.

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DB