Nice from Josh Hawes:
The two things that go hand in hand are reward and risk.
Yes simple, I know, but for some reason in all my travels and conversations it is often lost on investors.
Its natural for most people to concentrate on just the reward side in terms of return when it comes to investing, but you cannot think about reward without thinking about the cost.
For example what is more desirable, a 20% return with a 50% drawdown, or a 10% return with a 10% drawdown?
Sadly its not just the hunt for return that suffers from this one sided thinking but also when it comes to comparisons of performance.
Once again, most people if a person underperforms point out that they could’ve made 10% a year by parking their assets in an index.
To that we say all well and good, but are you willing to accept a 50% drawdown for that return?
You see you just cant think about reward without thinking about risk in any scenario.
For us we use a simple measure of gain to pain, the MAR ratio.
This ratio simply looks at your compound annual growth rate and divides it by your maximum drawdown.
It is a great tool in measuring “performance” both internally and externally.
To put it another way, I like to ask people this question, “How much did you pay for that drawdown?”
Sadly for most people when they see a manager that gets a 15% return and another that gets 11% they instinctively want to go with the manager that gets the higher return, even when they see that his drawdown is substantially larger than the other managers!
The manager with a 15% return might have exceptional skills at finding long only stocks that outperform but due to high correlation and market risk he still has 50% drawdown giving him a MAR of .3.
Compare that to the manager who gets an 11% return and only has a 20% drawdown with a MAR of .55, the less obvious choice is the better one!