Drawdown
A drawdown is the decline in an investment's value from its peak (highest point) to its trough (lowest point) before a new peak is reached. It measures how much an investment falls during a losing period and is one of the most important metrics for understanding investment risk.
Understanding drawdown
While returns tell you how much you have gained, drawdown tells you how much pain you might have to endure along the way. Even investments with excellent long-term returns can experience significant drawdowns that test investor resolve.
Formula: Drawdown = (Peak Value - Trough Value) / Peak Value × 100
Example: Your portfolio reaches $100,000, then drops to $75,000 before recovering
- Drawdown = ($100,000 - $75,000) / $100,000 × 100 = 25%
The mountain hike analogy
Imagine hiking up a mountain. Your overall journey takes you from sea level to 3,000 meters. But along the way, you might descend into valleys where you drop 500 meters before climbing again. The drawdown is like measuring how deep those valleys are. Even though you reach the summit eventually, those valleys can be exhausting and discouraging.
Why drawdown matters more than you think
Drawdown is psychologically and financially important for several reasons:
Psychological impact
Large drawdowns can cause investors to panic and sell at the worst time. Studies show that the pain of losing money is roughly twice as powerful as the pleasure of gaining the same amount. A 30% drawdown feels much worse than a 30% gain feels good.
Mathematical reality of recovery
Recovering from a drawdown requires a larger percentage gain than the percentage lost:
| Drawdown | Return Needed to Recover |
|---|---|
| 10% | 11.1% |
| 20% | 25.0% |
| 30% | 42.9% |
| 40% | 66.7% |
| 50% | 100.0% |
| 60% | 150.0% |
The recovery math is brutal
If your portfolio drops 50%, you need a 100% gain just to break even. This is why avoiding large drawdowns is often more important than chasing high returns. An investment that gains 8% per year with small drawdowns often outperforms one that gains 12% but experiences 40% drawdowns.
Historical drawdowns in context
Understanding historical drawdowns helps set expectations:
US Stock Market (S&P 500) major drawdowns
| Event | Period | Drawdown | Recovery Time |
|---|---|---|---|
| Great Depression | 1929-1932 | -86% | 25 years |
| Oil Crisis | 1973-1974 | -48% | 7.5 years |
| Dot-com Crash | 2000-2002 | -49% | 7 years |
| Financial Crisis | 2007-2009 | -57% | 5.5 years |
| COVID Crash | 2020 | -34% | 5 months |
| 2022 Bear Market | 2022 | -25% | 2 years |
Other asset classes
- Bitcoin: Has experienced multiple 80%+ drawdowns
- Gold: Dropped 46% from 1980-1982, took 28 years to recover
- Bonds: Typically experience smaller drawdowns (5-15%)
Maximum drawdown (MDD)
The maximum drawdown is the largest peak-to-trough decline over an investment's entire history. It represents the worst-case scenario an investor would have experienced.
When evaluating investments, always check the maximum drawdown. A fund might advertise 15% annual returns, but if its maximum drawdown was 60%, many investors would have sold in panic during that period and missed the recovery.
Using drawdown in investment decisions
Risk assessment
Compare investments not just by returns, but by returns relative to drawdowns:
- Investment A: 10% annual return, 15% max drawdown
- Investment B: 12% annual return, 40% max drawdown
Investment A might be preferable because the extra 2% return in B does not compensate for the nearly 3x higher drawdown.
Portfolio construction
Understanding drawdown helps with:
- Position sizing: Reduce allocation to assets with larger expected drawdowns
- Diversification: Combine assets with different drawdown patterns
- Risk tolerance matching: Choose investments whose drawdowns you can emotionally withstand
The Calmar Ratio
A useful metric that incorporates drawdown:
Calmar Ratio = Annualized Return / Maximum Drawdown
Higher is better. A ratio above 0.5 is decent; above 1.0 is excellent.
Strategies to manage drawdown
Diversification
Spreading investments across different assets reduces drawdowns because they rarely all decline simultaneously.
Asset allocation
Including bonds and other less volatile assets limits overall portfolio drawdown:
| Portfolio | Expected Return | Typical Max Drawdown |
|---|---|---|
| 100% Stocks | 10% | 50%+ |
| 80% Stocks / 20% Bonds | 9% | 35-40% |
| 60% Stocks / 40% Bonds | 8% | 25-30% |
| 40% Stocks / 60% Bonds | 6-7% | 15-20% |
Stop-loss strategies
Some investors use predetermined exit points to limit drawdowns, though this can result in selling low and missing recoveries.
Dollar-cost averaging
Continuing to invest during drawdowns means buying at lower prices, which can accelerate recovery.
The silver lining of drawdowns
While painful, drawdowns present opportunities. Investors who continued buying during the 2008 financial crisis or the 2020 COVID crash saw exceptional returns in subsequent years. If you have a long time horizon and stable income, drawdowns are opportunities to buy quality investments at discounted prices.
How much drawdown can you handle?
Before investing, honestly assess your risk tolerance:
- Conservative: 10-15% maximum drawdown tolerance
- Moderate: 20-30% maximum drawdown tolerance
- Aggressive: 30-50% maximum drawdown tolerance
If you would panic and sell during a 30% drawdown, you should not hold a 100% stock portfolio, regardless of the long-term return potential.
Related terms
- Volatility: Measures price fluctuations; related to but different from drawdown
- Return: The gain side of the risk/return equation
- Risk premium: Extra return expected for tolerating potential drawdowns
- Diversification: Primary strategy for reducing drawdown
- Portfolio: The collection of assets where drawdown is measured