Also called: Maximum drawdown.
Drawdown measures the experience of holding an investment rather than its average outcome. A portfolio that returned 8% a year while falling 55% along the way and one that returned 8% a year while never falling more than 15% are the same on a summary sheet and nothing alike to live through.
It matters because behaviour is where most plans fail. A deep drawdown is the moment people sell, and selling at the bottom converts a temporary paper loss into a permanent one. Knowing the worst fall a strategy has historically produced is a reasonable proxy for whether you would actually stick with it.
Recovery time is the other half. A 50% fall requires a 100% gain to get back to even, and the number of years that takes is the number of years the plan is not compounding from its previous high.
For anyone drawing an income, drawdown and sequence risk are the same problem seen from two angles: the fall is what does the damage, and withdrawing during it is what makes the damage permanent.
Research on this
- Sequence of Returns Risk: What If the Market Crashes the Year You Retire?
- Timing the Market vs Staying Invested: 40 Years of S&P 500 Evidence
See also
- Sequence of returns risk — The risk that the order in which investment returns arrive damages a plan, even when the average return is unchanged. It matters most when money is being withdrawn.
- Asset allocation — The split of a portfolio across asset classes — equities, bonds, cash, and others — which is the primary determinant of both its expected return and its volatility.
- Volatility drag — The gap between the average of a series of returns and the compound growth actually achieved. Higher volatility widens the gap, even with an unchanged average.