Drawdown Maths: The Rules That Keep You Investing After a Bad Year

A drawdown is the fall from a high point in the value of your portfolio to a later low. Most investors watch returns. The investors who last watch drawdowns too, because losses and gains do not cancel evenly. A loss needs a larger gain to undo, and that gap widens quickly as the loss deepens.

The recovery table

If a portfolio falls by a given percentage, the gain needed to return to the starting value is the loss divided by what remains. The third column shows roughly how long recovery would take if the portfolio then grew at an assumed 12 percent a year, a figure used only for illustration.

A 20 percent fall is uncomfortable but recoverable in a couple of years under that assumption. A 50 percent fall needs the money to double. A 75 percent fall needs it to quadruple. The curve is not a straight line, and that is the point: avoiding the deepest losses is worth more than it looks.

Why this changes how you invest

It means risk should be set from the downside. Many investors ask how much they might make. A more useful first question is how much they can afford to lose, and how long they can wait to recover. Once that is decided, position sizes, stop levels and the mix of assets follow from it.

Rule 1: Set a personal drawdown limit before you start

Choose the largest fall in your total portfolio that you could accept without changing your life or your behaviour. For some people this is 15 percent, for others 30 percent. Write it down. The number matters less than having one, because in a falling market the mind will argue for waiting one more week.

Rule 2: Link your limit to position sizes

If one position falls 30 percent and it makes up 5 percent of your portfolio, the portfolio loses 1.5 percent. If it makes up 40 percent, the portfolio loses 12 percent. The same stock, the same fall, a very different result. Our note on position sizing shows how to set the amount in each position from the loss you are willing to take.

Rule 3: Decide in advance what happens when the limit is reached

Pick the action while you are calm. It may be to cut exposure by a third, to stop adding new money for a period, or to review every holding against its original reason. What matters is that it is automatic and written down. A pre-decided rule removes the pull of loss aversion, which makes people hold losers in the hope of getting back to even.

Rule 4: Separate the money you need from the money you can wait with

A fall only becomes a permanent loss when you are forced to sell. Keep money needed within the next few years, such as an emergency fund and near-term expenses, in safe instruments. Then a market fall remains a number on a screen, not a reason to sell. It is the same idea as carrying the umbrella before the rain comes.

Rule 5: Write a one-page risk charter

• My goals and the dates by which I need the money.
• The largest portfolio fall I will accept.
• The most I will risk on one idea, as a percentage of the portfolio.
• What I will do if the limit is reached.
• How often I will review, and what would make me change the plan.

Read it once a quarter. Do not change it in the middle of a fall.

Common questions

Can I avoid drawdowns entirely?

No. Every strategy that takes risk will see falls. The aim is to keep them within a size you can recover from and live with.

Is a stop-loss the same as a drawdown limit?

They work at different levels. A stop-loss limits the loss on one position. A drawdown limit applies to the whole portfolio.

Does a deeper fall always mean a better recovery later?

No. The recovery table is arithmetic. It says what a recovery would require, not that it will happen or how fast.

The recovery figures are computed from the formula: required gain = fall / (1 - fall); years = ln(1/(1 - fall)) / ln(1.12). They are illustrations, not forecasts.