1. Performance metrics comparison
Comparing two investments through the cumulative or final wealth ignores the risk component in the performance.
You can overcome this by using metrics such as the Sharpe ratio, the Sortino ratio, and the maximum drawdown.
2. Sharpe and Sortino ratios
You are already familiar with the Sharpe and the Sortino ratios.
These indicators report the reward obtained per unit of risk taken. For the Sharpe ratio, the risk is measured with the volatility. For the Sortino ratio, the risk is measured with the semideviation.
When benchmarking your investment, you want both metrics to be higher than the ones of the benchmark.
3. Maximum drawdown
Another benchmarking tool popular among practitioners is the maximum drawdown.
We define a drawdown as the peak-to-trough decline of the value of investment during a specific period. Usually, it is quoted as a percentage of the peak value.
The maximum drawdown is the largest of these differences observed over the whole past period.
4. Capital preservation
The drawdown metric is based on the principle that capital preservation is crucial for investors.
Let's take an example. If a stock whose value is $100 loses 1% and goes to $99, it only needs an increase of 1.01% to recover.
However, a drop of 50% would push the stock to $50, and investors would require a return of 100% to recover their initial capital.
A drawdown of 50% is dangerous for capital preservation!
5. Metric of capital preservation
Benchmarking your investment using the maximum drawdown allows you to include capital preservation in your analysis.
Suppose for instance that with your investment you realize monthly returns of 5%, -5%, 5%, -5%, while in the same period the benchmark generates 5%, 5%, -5%, -5%.
6. Metric of capital preservation
Both have the same returns, the same volatility, the same Sharpe ratio, but your investment is better as it has a more limited maximum drawdown than the benchmark. We clearly notice this on the plot, where the cumulative loss is displayed in percentages in the vertical axis.
7. Drawdowns with Google Sheets
Finding the drawdowns and the maximum drawdown with spreadsheets is a two-step process.
Given the series of historical prices, start by computing the first drawdown, which is zero as you divide the current price by itself, and then subtract one from the result.
8. Drawdowns with Google Sheets
Next, you can compute the various drawdowns for the period under analysis using the "autofill" feature.
9. Drawdowns with Google Sheets
The drawdown at a given date is defined as the current price divided by the historical maximum price so far, minus one.
10. Maximum drawdowns with Google Sheets
Once you have obtained all the drawdowns, the maximum drawdown is the largest drawdown. We express it in absolute value. So just take the negative value of the minimum.
It can be found using the function MIN() preceded by the minus sign.
11. It's time to practice!
Let's continue your benchmarking exercise with the Sharpe ratio and the drawdowns. Time to practice!