Expected Drawdown Management: An Ex-Ante, Long-Term Approach to Portfolio Construction

Abstract

This article describes a different approach to constructing portfolios; one based on the investor’s forward-looking, long-term expectation of peak-to-trough loss from investments (expected drawdown). The argument is made that expectation of the future peak-to-trough loss from an investment should be used as a true measure of risk capital that the investor is committing to the investment. This article further introduces a new metric that quantifi es the investor’s ex-ante view that two investments will experience their expected drawdowns at the same time (the expected co-drawdown). These two metrics combine into a new portfolio construction methodology (expected drawdown management) allowing investors to optimally construct portfolios based on controlling for the investor’s expectation of future peak-to-trough loss at the portfolio level.