Drawdowns: why duration matters more than depth

Drawdown is the fall from a previous peak to a trough. Maximum drawdown answers the question of what would have had to be endured, and it is the most honest risk measure among the simple ones.

The arithmetic of recovery

It is asymmetric, and that is the main thing to know about it. Recovering from a fall of a third requires a rise of a half. The deeper the hole, the disproportionately harder the climb out.

But depth is not what breaks people

Time does. Five years underwater destroy discipline more reliably than one sharp crash: a crash is lived through as an event, while years of going nowhere feel like a verdict. It is in the fourth year that people sell at the bottom.

What to do about it

Look at the drawdown before entering a position rather than after. The question "could I withstand this" is asked in advance — later it is answered by something other than reason.

Diversification reduces a drawdown only while assets do not fall together. In a crisis correlations converge on one, and a portfolio of thirty securities from a single market falls like a single security.