Drawdown

A drawdown is how far an asset fell from a peak to a trough, and the largest such fall is the maximum drawdown. If a portfolio went from $100,000 to $60,000, that drawdown was 40%.

Its value is showing what a return figure hides. Two funds may both compound at 10% a year, but if one dipped 15% at worst and the other 55%, the experience is nothing alike. Most people cannot hold through the second one, and by selling they never receive that 10%.

Drawdowns are also frightening because recovery is asymmetric. A 50% fall needs a 100% gain to break even, and a 70% fall needs 233%. For reference, the S&P 500 fell roughly 50% from its peak both in the early 2000s and in 2008. Even index investing has passed through stretches like that.

In practice, use it this way: before choosing an investment, ask whether you could stick to your plan if your money shrank by that asset's historical maximum drawdown. If the answer is no, it is too risky for you regardless of its returns. Asset allocation and rebalancing are less about raising returns than about cutting drawdowns down to a size you can actually endure.