A drawdown is the amount your investment or account value falls from its highest point (peak) to its lowest point (trough) before it recovers. Drawdowns are a normal part of investing, but they’re also one of the most misunderstood—and emotionally challenging—concepts for beginners.
Understanding drawdowns is essential because every investor experiences them. The key to long-term success isn’t avoiding drawdowns entirely (that’s impossible), but knowing how big they can be, how long they can last, and how to manage them without making costly mistakes.
This beginner-friendly guide explains what drawdowns are, how they work, why they matter, and how real investors experience them in practice.
What Is a Drawdown?
A drawdown measures the percentage decline from a previous high point in your portfolio or investment.
It answers this question:
How much has my account fallen from its highest value before recovering?
Simple example:
- Your portfolio grows from $50,000 to $100,000 (new peak)
- Market declines reduce it to $80,000
- Your drawdown is 20%
The drawdown lasts until your account value rises above $100,000 again and sets a new peak.
Why Drawdowns Matter
Drawdowns matter because they directly affect:
- Your emotional response to investing
- Your ability to stay invested
- Your long-term returns
Most investors don’t fail because their strategy is bad—they fail because they abandon their strategy during a drawdown.
Understanding drawdowns helps you:
- Set realistic expectations
- Choose investments you can stick with
- Avoid panic selling
- Align strategy with risk tolerance and risk capacity
Drawdown vs. Loss (Important Distinction)
Drawdown is not the same as a realized loss.
- Drawdown: Temporary decline from a peak
- Loss: Permanent reduction after selling
If your portfolio falls 25% but you don’t sell and it later recovers, the drawdown was temporary. If you sell during the decline, the drawdown becomes a real loss.
This distinction is crucial—most long-term market losses are caused by investor behavior, not markets themselves.
How Drawdown Is Calculated
Drawdown is usually expressed as a percentage.
Formula (simplified):
(Peak Value − Lowest Value) ÷ Peak Value
Example:
- Peak: $200,000
- Trough: $140,000
- Drawdown: ($200,000 − $140,000) ÷ $200,000 = 30%
Drawdowns can be calculated for:
- Individual stocks
- Portfolios
- Indexes
- Trading strategies
Types of Drawdowns
1. Small Drawdowns
- 5–10% declines
- Common and frequent
- Often recover quickly
These happen regularly—even in strong markets.
2. Moderate Drawdowns
- 10–20% declines
- Often linked to market corrections
- Can last months
Many investors underestimate how uncomfortable these feel in real time.
3. Large Drawdowns
- 30%+ declines
- Occur during bear markets or crises
- Can take years to recover
These are the drawdowns that test discipline and long-term commitment.
Drawdowns in the Stock Market
Even long-term successful markets experience deep drawdowns.
Broad indexes like the S&P 500 have historically:
- Delivered strong long-term returns
- Experienced multiple drawdowns of 30–50%
These drawdowns are not signs of failure—they are part of the cost of earning higher long-term returns.
Drawdown and Recovery: The Math Most People Miss
One of the most important concepts beginners overlook is that losses and gains are not symmetrical.
| Drawdown | Gain Needed to Recover |
| 10% | 11% |
| 20% | 25% |
| 30% | 43% |
| 40% | 67% |
| 50% | 100% |
The deeper the drawdown, the harder it is to recover.
That’s why managing drawdowns—rather than chasing maximum returns—is so important.
Drawdown Duration Matters Too
Drawdowns aren’t just about how deep they go—but also how long they last.
Some drawdowns:
- Recover in weeks or months
- Feel uncomfortable but manageable
Others:
- Last several years
- Test patience and confidence
- Require strong emotional discipline
Long drawdowns are often more damaging psychologically than sharp, fast ones.
Drawdown vs. Volatility
Drawdown and volatility are related but different.
- Volatility: How much prices fluctuate day to day
- Drawdown: How far prices fall from a peak
An investment can be volatile but recover quickly, resulting in small drawdowns. Another may move slowly downward, producing a large drawdown with less daily volatility.
Investors often tolerate volatility better than prolonged drawdowns.
Real-Life Drawdown Examples
Example 1: Long-Term Investor
An investor contributes monthly to a diversified portfolio. During a market downturn, the account drops 25%.
- Investor continues investing
- Portfolio recovers over time
- Drawdown is temporary
Result: Long-term plan stays intact.
Example 2: Panic Seller
Another investor experiences the same 25% drawdown but sells near the bottom.
- Locks in losses
- Misses the recovery
- Must restart from a lower base
Result: Drawdown becomes permanent damage.
Example 3: Over-Leveraged Trader
A trader uses leverage. A 10% market move causes a 40% drawdown.
- Account becomes difficult to recover
- Emotional stress increases
- Strategy may fail entirely
Result: Large drawdowns plus leverage often end trading careers.
Maximum Drawdown (Max Drawdown)
Maximum drawdown is the largest peak-to-trough decline over a given period.
It’s a key metric used to:
- Compare investment strategies
- Evaluate risk
- Assess worst-case scenarios
A strategy with slightly lower returns but much smaller maximum drawdown may be preferable for many investors.
Drawdown and Risk Tolerance
Your ability to endure drawdowns depends on:
- Risk tolerance (emotional comfort)
- Risk capacity (financial ability to absorb losses)
- Time horizon
If a 20% drawdown causes panic, your portfolio is too aggressive—regardless of its expected return.
Managing Drawdowns (Practical Strategies)
1. Diversification
Spreading investments across asset classes reduces the severity of drawdowns.
2. Asset Allocation
Balancing stocks, bonds, and cash helps limit large declines.
3. Time Horizon Matching
Money needed soon should not be exposed to large drawdowns.
4. Avoiding Leverage
Leverage magnifies drawdowns and recovery difficulty.
5. Behavioral Discipline
Sticking to a plan matters more than predicting markets.
Common Beginner Mistakes With Drawdowns
- Expecting to avoid them
Every strategy has drawdowns. - Selling during maximum pain
This turns temporary declines into permanent losses. - Overestimating tolerance
Drawdowns feel very different in real time. - Focusing only on returns
High returns mean nothing if you can’t survive the drawdowns.
Drawdowns and Long-Term Success
Successful investing is not about:
- Perfect timing
- Avoiding downturns
- Never losing money
It’s about:
- Surviving drawdowns
- Staying invested
- Letting compounding work over time
Investors who understand drawdowns are far more likely to stay the course.
A Simple Rule of Thumb
If a drawdown of 25–30% would cause you to:
- Panic sell
- Abandon your plan
- Lose sleep consistently
Then your investment strategy is too risky for you—no matter how attractive the long-term returns appear.
Drawdown Is the Price of Admission
Every asset with meaningful long-term returns comes with drawdowns. They are not flaws—they are the price of admission for growth.
The real risk is not experiencing drawdowns.
The real risk is reacting poorly to them.
Final Thoughts
A drawdown is the decline in account value from a peak before recovery. It is one of the most important—and emotionally challenging—realities of investing. Drawdowns are unavoidable, unpredictable, and uncomfortable—but they are also temporary for disciplined, long-term investors.
For beginners, understanding drawdowns early can prevent costly mistakes later. When you expect them, plan for them, and size your risk appropriately, drawdowns become manageable obstacles rather than reasons to quit.
In investing, success doesn’t come from avoiding downturns—it comes from surviving them.
Frequently Asked Questions About Drawdowns
What is drawdown in investing?
Drawdown refers to the percentage decline from an investment’s peak value to its lowest point before it recovers. It measures how much a stock, fund, or portfolio has fallen during a losing period.
Why is drawdown important for investors?
Drawdown is important because it reflects real downside risk. Large drawdowns can cause emotional stress, lead to panic selling, and significantly delay portfolio recovery. Understanding drawdowns helps investors manage risk more effectively.
What is the difference between drawdown and volatility?
Volatility measures how much prices fluctuate over time, while drawdown measures the size of a peak-to-trough loss. An investment can experience frequent price swings (volatility) without suffering a deep drawdown, and vice versa.
How do drawdowns affect long-term returns?
Large drawdowns require proportionally larger gains to recover. For example, a 20% drawdown requires a 25% gain to break even, while a 50% drawdown requires a 100% gain. Managing drawdowns is critical for protecting long-term compounding.
How can investors reduce drawdowns?
Investors can reduce drawdowns through diversification, appropriate asset allocation, disciplined risk management, and avoiding emotional decisions during market stress. The goal is not to eliminate drawdowns but to keep them within manageable levels.