Understanding drawdowns before tactical allocation in a portfolio

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Subscribe to enjoy similar stories. Volatility is the lifeblood of financial markets. It creates profit opportunities but is also the source of sleepless nights for many investors.

While some thrive on the adrenaline rush of market fluctuations, others shy away, deterred by the potential for losses. However, savvy investors understand that managing risk is equally critical. This is where the concept of drawdowns becomes invaluable, especially regarding tactical asset allocation.

But why should investors take the time to understand drawdowns before making tactical allocations in their portfolios? The answer lies in the nature of investing itself. Tactical asset allocation is a strategy that allows investors to capitalise on short-term market opportunities. Unlike its more static counterpart---strategic allocation---tactical moves require a keen understanding of market dynamics and the ability to act swiftly.

These short-term adjustments to a portfolio's asset mix can potentially enhance returns, but they also come with increased risk. Here’s where drawdowns enter the picture. For context, drawdown measures the decline in an asset's value from its peak to its lowest point over a specific period.

It's a powerful indicator of an investment's volatility and potential risk, making it crucial for tactical allocations. By understanding the typical drawdowns of an asset class, as well as the associated recovery periods, investors can make more informed decisions about whether that asset fits their tactical strategy. A high recovery period indicates that it takes a significant amount of time for the asset to recover from a drawdown, while a low recovery period suggests a relatively quick rebound.