Why Drawdowns Matter: A Visual Demonstration

Common knowledge in investment circles is that drawdowns are bad. But are they always bad? Are there times when they’re especially bad?

Let’s explore these questions by looking at stocks and bonds. From 2001-2016, the S&P 500 returned +133% and the Barclays US Agg. Bond Index returned +112%. In this time period, the cumulative returns of stocks and bonds were fairly close, but the return patterns were very different.

The chart below shows the growth of a $100,000 investment in these two indices. As you can see, stocks had significant drawdowns during the period while bonds were less volatile. If you simply bought and held for the 16-year period, you would receive a +133% return in stocks and +112% return in bonds. Your account balance would have ended about 10% higher investing in stocks than bonds.

The next chart shows the same initial investment of $100,000, but this time let’s assume you deposit/buy an additional $500 per month. You will notice that under this scenario, stocks worked a little bit better—your ending balance would have been 25% higher investing in stocks than bonds.

The third chart shows the same initial investment of $100,000, but let’s assume you sell/withdraw $500 per month. You will notice that under this scenario, bonds did much, much better—your ending balance would have been 154% higher investing in bonds than stocks.

The three scenarios above illustrate the drastically different outcomes that are possible when investing in the same two indices. The only difference between each scenario is the assumption that you made deposits or withdrawals along the way.

What it means:

The three scenarios above demonstrate the importance of drawdowns depending on your situation.

1) If you make no trades, the return pattern doesn’t matter—the only thing that matters is your return. Of course, this is not how most people invest.

2) If you’re depositing on a regular basis (e.g., a young person with a 401(k)), big stock market drawdowns shouldn’t scare you. In fact, drawdowns help you, because they allow you to buy more shares at a lower price.

3) If you’re withdrawing on a regular basis (e.g., a retiree), drawdowns matter a lot. If you sell during a drawdown, you have to sell a larger quantity of shares to get the same dollar proceeds.

This is not a comment on the behavioral effects of volatility. These scenarios assume you can stick to a regular plan.

The above simply demonstrates  how much return patterns matter depending on the investor’s situation. Drawdowns are not always bad, and can be beneficial to someone  with a long time horizon who is dollar-cost averaging. But drawdowns are absolute killers if you’re making regular withdrawals.

Postscript (Into the Weeds)

I often see discussions of the negative effects of volatility. For example, this Michael Batnick post makes the valuable point that “outsized volatility is a drag on returns.” It shows how a portfolio can erode over time if it experiences alternating gains and losses.

The below chart shows what happens over time to a dollar if it experiences alternating gains and losses of +10%/-10%, and +20%/-20%:

But here’s the thing: volatility is not what causes the value to drop. The reason is that a gain of 10% is not equivalent to a loss of 10%.

If you lose 20%, you need a 25% return to get back to zero. So -20% is equivalent to +25%.

To find the equivalent loss for a gain of 10%, we can use the formula 1/(1+r)-1, which in this case is about -9.09%. This is because single-period returns are compounding, not additive.

In other words, a single-period return of 10% is actually equivalent to a loss of 9.09%. You could alternate returns of +10% and -9.09% forever and never fall below your original dollar.

A portfolio can experience equivalent gains and losses forever, but the trick here is that +10% is not equivalent to -10%, and +20% is not equivalent to -20%.