DRAWDOWNS EXPLAINED: MANAGING INVESTMENT EXPECTATIONS

What Is a Drawdown?

A drawdown refers to a decline in the value of an investment portfolio from its peak to its subsequent trough, usually expressed as a percentage. It is a standard metric used by investors to assess the risk associated with a particular investment or strategy.

For example, if a portfolio peaks at £100,000 and then declines to £85,000 before recovering, the drawdown would be calculated as:

• (£100,000 - £85,000) / £100,000 = 15% drawdown

Drawdowns are a normal and inevitable part of investing, particularly in equities and other risk assets. However, their depth and frequency can significantly affect long-term returns and investor psychology.

Types of Drawdowns

• Peak-to-Trough Drawdown: The maximum drop between a portfolio’s high and its subsequent low, regardless of timeframe.
• Rolling Drawdown: A moving measurement of downturns over a set historical period, often used in performance reports.
• Absolute Drawdown: The monetary or percentage drop from the initial investment capital to the lowest level reached.

Impact of Drawdowns on Investing

Understanding drawdowns is essential for investors to develop realistic performance expectations and to select appropriate investment strategies aligned with their risk tolerance. Large drawdowns may require equivalent or greater returns to break even. For example, a 50% drawdown requires a 100% return to recover—a fact that underscores the asymmetric nature of losses and gains in investing.

Psychological Effects of Drawdowns

Drawdowns can significantly impact an investor’s behaviour. During periods of sharp decline, many may panic and liquidate holdings at the worst possible time. Other investors may become overly conservative after a drawdown, missing opportunities during market recoveries. Effective management of expectations and deep understanding of one's investment time horizon are needed to ride out market volatility.

Historical Examples

Major global drawdowns include the 2008 Global Financial Crisis, which saw equity markets fall by over 50%, and the 2020 COVID-19 panic, during which markets dropped over 30% in a month. However, in both cases, markets recovered, and long-term investors who held on were eventually rewarded.

Conclusion

Drawdowns are a reality of investing, not anomalies. Recognising their inevitability and understanding their causes and outcomes helps investors prepare mentally and structurally for turbulence in markets. Instead of avoiding risk entirely, successful investors manage and anticipate drawdowns within a broader framework of risk tolerance, diversification, and long-term strategy.

Why Managing Drawdowns Is Crucial

Managing drawdowns is an essential part of any sound investment strategy. Drawdowns affect not only the statistical metrics of portfolio performance, but also an investor’s emotional resilience and behaviour during volatile periods. By actively preparing for drawdowns, investors can ensure they stay the course and avoid making emotional and potentially harmful decisions during periods of market stress.

Key Strategies to Manage Drawdowns

There are various techniques and methodologies that investors can employ to reduce the impact of drawdowns:

• Diversification: Allocating assets across various classes (stocks, bonds, commodities, property, cash) ensures no single asset can significantly impair overall performance.
• Risk Allocation: Position sizing should align with one’s risk tolerance. Avoid concentrated bets, and rebalance regularly to prevent unchecked exposure to a single asset or sector.
• Stop Losses and Hedging: Tactical tools such as stop-loss orders or options-based hedges can provide downside protection in turbulent periods.
• Tactical Asset Allocation: Adjusting exposures based on economic and market indicators, while not timing the market perfectly, can still moderate deep losses when applied prudently.
• Quality Investments: Focusing on assets and businesses with solid fundamentals, strong balance sheets, and resilient cash flows often leads to quicker post-drawdown recovery.

Setting Realistic Expectations

Many investors enter the market with unrealistic return expectations—fuelled often by recent trends or media headlines. Expecting consistent double-digit growth annually is not only improbable but sets the stage for disappointment during inevitable market corrections.

Historical market data indicates average annual returns of around 7–8% for equities over the long term, coupled with intermittent corrections and bear markets. Understanding these averages—and that drawdowns are statistically normal within this context—helps ground expectations appropriately.

Maintaining Liquidity

Liquidity management is another often-overlooked factor in drawdown mitigation. Maintaining an emergency fund or cash buffer enables investors to avoid liquidating long-term investments during down periods, allowing the portfolio time to recover naturally.

The Importance of Patience and Discipline

Disciplined adherence to long-term strategy is often the most effective response to drawdowns. While tactical adjustments and risk techniques can help, staying invested through the downturn, continuing systematic contributions, and allowing time for recovery are historically proven paths to success.

Using drawdowns as learning moments—examining what caused them, how the strategy responded, and whether changes are needed—also increases investor resilience and understanding.

Professional Advice and Tools

For individuals lacking the time or expertise to implement active drawdown strategies, professional advice can be invaluable. Financial advisers can help assess risk tolerance, construct diversified portfolios, and maintain emotional discipline during volatile markets. Additionally, portfolio analytical tools and robo-advisers often provide real-time drawdown monitoring and rebalancing features that contribute to overall risk control.

Conclusion

Managing drawdowns requires a structured, multi-faceted approach that includes proper asset allocation, disciplined investment execution, and emotional preparation. By accepting drawdowns as part of the investment cycle and planning accordingly, investors can navigate them intelligently—protecting capital and positioning for future growth.

Investment Horizons and Objectives

Investor expectations must match the realities of investing, particularly the timeframe involved. Generally, long-term investments require a tolerance for both market volatility and periodic drawdowns. If an investor’s goals are long-term—such as retirement in 20–30 years—the focus should be on compounded returns, rather than short-term price movements.

Short-term expectations not only misalign with the nature of many asset classes (such as equities), but they can also trigger panic-induced decisions during normal market corrections.

Historical Context Builds Expectations

Studying long-range market performances helps frame expectations with accuracy. For example, although global equities have returned around 7–8% annually over long periods, they have also experienced intra-year declines of 10–20% regularly. Understanding this dual reality reinforces that volatility coexists with attractive long-term returns.

Similarly, bond markets may offer lower volatility, but they come with lower growth potential. Choosing the right mix of assets depends on each investor’s personal investment horizon, income needs, and tolerance for drawdowns.

Risk and Return Are Related

Higher returns invariably involve greater volatility. Seeking 15–20% annual growth necessitates exposure to higher-risk assets, which can routinely present double-digit drawdowns. Being comfortable with this cyclical fluctuation is critical—investor disappointment often stems from a mismatch between desired returns and accepted risk profiles.

Investor profiling tools used by advisers can help align strategies to individual risk tolerance, investment objectives, and capacity to handle drawdowns—ensuring decisions remain rational across market cycles.

The Role of Communication and Transparency

For institutional investors or advisers managing client portfolios, education and open communication are essential. Setting expectations clearly can prevent misalignment during periods of volatility. Portfolio drawdowns should be discussed proactively, not reactively, with comparisons to benchmarks and historical analogues providing useful perspective.

Simulation and Scenario Analysis

Investors can also use stress tests, backtesting, and scenario modelling to anticipate potential future drawdowns under different economic environments. Understanding the range of possible outcomes—before it becomes reality—reduces behavioural risk and increases preparedness.

Creating an Investment Policy Statement (IPS)

An IPS is a written document that outlines investment goals, acceptable risk levels, asset allocation targets, and behavioural guidelines during market stress. Having an IPS formalises expectations, reduces emotionally driven reactions, and acts as a roadmap for resilience during drawdown events.

Ongoing Review and Adaptation

Markets evolve, and so do personal financial situations. Periodic reviews of strategy, performance, and expectations ensure alignment remains intact. Whether after life events, market upheavals, or changes in risk appetite, rebalancing expectations is just as important as rebalancing portfolios.

Conclusion

Setting and managing expectations is a vital pillar in long-term investing success. By acknowledging risk, understanding historical cycles, embracing drawdowns as part of the return journey, and maintaining flexibility, investors can confidently remain engaged with their portfolios through both bear and bull markets.