Volatility and maximum drawdown

In simple terms

Average returns describe a portfolio on paper. What investors actually live through is the path: good years, bad years, and the falls in between. Two measures capture that path:

• Volatility: how much returns swing around their average, measured as the standard deviation of returns, as the averages and volatility lesson explains.
• Maximum drawdown: the largest fall from a peak to a later low.

Volatility is the textbook measure. Drawdown is the one people feel.

A worked example

Three things stand out:

1. The average (7.4%) is higher than the growth actually achieved (6.3% a year). Losses hurt compounding more than equal gains help, a gap often called volatility drag. The compounding lesson showed why the average of returns misleads.
2. Volatility of about 16% means that in a typical year, returns were roughly 16 points above or below the average.
3. A 20% drawdown happened even though the portfolio nearly doubled over ten years. An investor who sold in panic at the low would have missed the recovery.

Recovery takes larger gains, and time

A fall of X% needs a gain larger than X% to recover:

The loss recovery calculator works this out for any fall. Recovery time depends on the returns that follow. Broad share markets have at times taken several years to regain previous peaks after deep falls, as the bull and bear markets lesson describes.

Allocation drives both measures

A portfolio's volatility and drawdowns come mainly from its asset allocation. More equity means bigger swings and deeper drawdowns; more fixed income means smaller ones. Diversification across holdings reduces company-specific falls, but cannot remove market-wide ones, as the diversification lesson explains.

Why drawdowns matter more than volatility

Volatility treats rises and falls symmetrically, and it is an abstract number. Drawdowns describe the actual experience of watching savings shrink, and they are when people abandon plans. So a useful question when choosing a portfolio is not "what is its volatility?" but "could I hold on through its worst historical drawdown, without selling, while the news is grim?"

If the honest answer is no, choose a portfolio with smaller drawdowns, even at the cost of lower expected returns. A plan you stick with beats a better plan you abandon, as the risk tolerance lesson explains.

Why it matters

Investors who look only at average returns are often shocked by the falls along the way, and react badly. Measuring volatility and drawdowns, and testing yourself against them, sets realistic expectations and helps you choose a portfolio you can actually live with.

Limitations

Both measures are calculated from history and depend on the period chosen. Future drawdowns can be larger than any in the data. Volatility assumes returns are spread evenly around the average, which they often are not; extreme falls happen more often than such measures suggest.

Common mistakes

• Judging a portfolio by its average return alone.
• Forgetting that the average overstates compound growth.
• Assuming the worst drawdown in your data is the worst possible.
• Choosing a portfolio whose drawdowns you could not tolerate.

Try it yourself

1. Take ten years of yearly returns for an index fund or a mix of funds.
2. Calculate the average, the standard deviation and the compound annual growth rate.
3. Build the value of ₹100 year by year and find the maximum drawdown.
4. Write down whether you would have held on through that drawdown.