References (27)


Footnotes (7)



Drawdown-Based Stop-Outs and the 'Triple Penance' Rule

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Marcos Lopez de Prado

Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; RCC at Harvard University

November 2013

How long does it take for a portfolio manager to recover from a drawdown? We find that, under standard portfolio theory assumptions, the answer is strikingly unequivocal: On average, it takes three times the period elapsed between the high-watermark and the maximum drawdown, a principle we denote the “triple penance rule”.

We provide a theoretical justification to why investment firms typically set less strict stop-out rules to portfolio managers with higher Sharpe ratios, despite the fact that they should be expected to deliver superior performance. We generalize this framework to the case of first-order auto-correlated investment outcomes, and conclude that ignoring the effect of serial correlation leads to a gross underestimation of the downside potential of hedge fund strategies, by as much as 70%. We also estimate that some hedge funds may be firing more than three times the number of skillful portfolio managers, compared to the number that they were willing to accept, as a result of evaluating their performance through traditional metrics, such as the Sharpe ratio.

We believe that our closed-form compact expression for the estimation of drawdown potential, without having to assume IID cashflows, will open new practical applications in risk management, portfolio optimization and capital allocation. The Python code included confirms the accuracy of our analytical solution.

Number of Pages in PDF File: 40

Keywords: drawdown, time under water, stop-out, triple penance, serial correlation, Sharpe ratio

JEL Classification: G0, G1, G2, G15, G24, E44

working papers series

Download This Paper

Date posted: January 16, 2013 ; Last revised: November 24, 2013

Suggested Citation

Bailey, David H. and Lopez de Prado, Marcos, Drawdown-Based Stop-Outs and the 'Triple Penance' Rule (November 2013). Available at SSRN: http://ssrn.com/abstract=2201302 or http://dx.doi.org/10.2139/ssrn.2201302

Contact Information

David H. Bailey
Lawrence Berkeley National Laboratory ( email )
One Cyclotron Road
Berkeley, CA 94720
United States
HOME PAGE: http://www.davidhbailey.com
University of California, Davis ( email )
One Shields Avenue
Davis, CA 95616
United States
HOME PAGE: http://www.davidhbailey.com
Marcos Lopez de Prado (Contact Author)
Guggenheim Partners, LLC ( email )
330 Madison Avenue
New York, NY 10017
United States
HOME PAGE: http://www.QuantResearch.info
Lawrence Berkeley National Laboratory ( email )
One Cyclotron Road
Berkeley, CA 94720
United States
HOME PAGE: http://www.lbl.gov
RCC at Harvard University ( email )
26 Trowbridge Street
Cambridge, MA 02138
United States
HOME PAGE: http://www.rcc.harvard.edu
Feedback to SSRN

Paper statistics
Abstract Views: 3,429
Downloads: 1,081
Download Rank: 9,460
References:  27
Footnotes:  7

© 2014 Social Science Electronic Publishing, Inc. All Rights Reserved.  FAQ   Terms of Use   Privacy Policy   Copyright   Contact Us
This page was processed by apollo6 in 0.500 seconds