EQUITY RISK EXPLAINED: DRAWDOWNS, VOLATILITY & BIASES

Equity risk refers to the potential for losses arising from holding shares in publicly traded companies. Unlike fixed-income securities that often offer pre-defined returns, equities are subject to dynamic and unpredictable market forces. These can range from company-specific events to broader macroeconomic developments such as interest rate changes, inflation, and geopolitical tensions. As such, equity investors are exposed to a range of risks that can lead to temporary or permanent capital losses.

Importantly, equity risk encompasses not only measurable forms of risk, like price volatility and market drawdowns, but also intangible risks related to investor behaviour. Cognitive biases, emotional decision-making, and herd mentality often exacerbate market fluctuations, leading to suboptimal investment outcomes. Understanding and managing these multiple dimensions of equity risk is essential for constructing resilient portfolios and maintaining long-term performance.

In this guide, we explore the three main categories of equity risk: drawdowns, volatility, and behavioural mistakes, each of which can influence the performance of an investment portfolio.

Drawdowns are among the most critical and visible forms of equity risk. A drawdown occurs when the market value of an investment drops from a previous high to a trough, typically measured as a percentage of the peak value. Investors monitor drawdowns to assess the severity of losses during market downturns and determine the recovery period required to reach previous asset levels.

There are several points to understand about drawdowns:

• Magnitude: The size of the drop from peak to trough—e.g., a 20% drawdown from a portfolio value of £1,000,000 indicates a £200,000 decline.
• Duration: The time it takes the investment to recover from the bottom back to its previous peak. Some drawdowns resolve within months; others can take years (notably during crises like the 2008 Global Financial Crisis).
• Frequency: How often these events occur. Drawdowns of 10–20% are relatively common in equity investments and investors should be prepared for such fluctuations as a normal part of equity investing.

Drawdowns can result from various factors including macroeconomic declines, sector-specific downturns, corporate mismanagement or broader events like pandemics or military conflicts. Investors with shorter time horizons or lower risk tolerance tend to find significant drawdowns especially challenging, often leading to emotionally-driven selling at inopportune times.

Understanding the concept of drawdowns helps investors contextualise short-term losses, set realistic expectations, and plan ahead for potential cash flow needs. Through diversification, risk budgeting and scenario analysis, market drawdown risk can be mitigated to some extent, although not fully eliminated.

Historical analysis suggests that equity markets eventually recover from drawdowns but the path to recovery can be volatile and uncertain. For instance, the MSCI World Index experienced drawdowns exceeding 30% on several occasions over the last 50 years, but long-term oriented investors who remained invested often benefitted from substantial gains in the subsequent recovery.

Ultimately, investors must accept that drawdowns are a normal feature of investing in equities. Planning for such occurrences, both strategically and psychologically, is essential for maintaining composure and long-term discipline during market stress.

Volatility is another key aspect of equity risk and refers to the degree of variation in the price of a stock or portfolio over time. It is typically measured by standard deviation, which quantifies how much returns deviate from the average. A high standard deviation implies greater uncertainty and a wider range of possible outcomes.

From a practical standpoint, volatility influences investor sentiment, perceived risk, and portfolio value. Sudden and sharp price changes can induce fear or overconfidence, often prompting frequent trading decisions that may be detrimental to long-term outcomes. It's crucial for investors to differentiate between short-term noise and meaningful directional trends.

Often, volatility is classified in two forms:

• Historical volatility: The degree of actual past movement in a stock's price over a given period.
• Implied volatility: The market's forecast of likely price movements, commonly derived from options pricing models like Black-Scholes.

Volatility does not inherently equate to risk, especially over the long term. While risk-averse investors may view high volatility as negative, some strategies—such as momentum investing—aim to harness volatility for profit. However, high volatility can reduce portfolio stability and may increase the likelihood of executing poorly timed trades based on emotional responses.

Moreover, volatility tends to spike during periods of uncertainty or economic stress. The COVID-19 pandemic in 2020 and the onset of the Russia-Ukraine conflict in 2022 serve as recent examples where fear pushed volatility indices like the VIX to extreme levels, prompting widespread market sell-offs. These high-volatility episodes often coincide with significant drawdowns, compounding overall equity risk.

Portfolio diversification, the use of low-volatility equity funds, and systematic rebalancing can help manage the effects of volatility. Additionally, long-term investors are often advised to ignore short-term fluctuations and instead focus on long-range goals, asset allocation, and disciplined investment strategies.

Understanding volatility and its impact on portfolios is essential not only for anticipating potential price gyrations but also for adjusting expectations and maintaining investment discipline. Recognising that fluctuations are part and parcel of the investment journey can help investors stay the course and reduce the risk of harmful reactions during turbulent times.