Risk, return and drawdowns

Every investment involves risk. The question is not how to avoid it, but how to take the right amount — enough to grow, never so much that you are forced to sell at the bottom.

Two ways to describe risk

• Volatility measures how much a price swings. It is the standard measure used by professionals.
• Drawdown measures how far an investment falls from its previous high. It is the risk you actually feel.

Most private investors do not quit because of volatility. They quit after a deep drawdown — usually close to the bottom.

The maths of losses

Losses and gains are not symmetric. After −10% you need +11% to recover. After −50% you need +100%. After −80% you need +400%. Deep losses also take years to repair: the S&P 500 needed more than a decade after 2000 to make new highs in real terms, and the Nasdaq-100 needed about fifteen years to regain its 2000 peak.

Measuring return per unit of risk

Comparing returns without risk is misleading. The Sharpe ratio divides the return above cash by volatility: a higher number means you were paid more for each unit of fluctuation. Always look at three numbers together: CAGR, maximum drawdown and Sharpe.

Know your own risk capacity

Ask two questions. How much could your portfolio fall before you would lose sleep or sell? And when will you need the money? Money needed within a few years should not sit in volatile assets. Money for the long term can take more risk — as long as you can truly hold through the drawdowns.

Key takeaways

• Volatility is how risk is measured; drawdown is how it feels.
• Big losses need much bigger gains to recover.
• Judge investments by return, drawdown and Sharpe ratio together.
• Take only the risk you can hold through a crash.

By Dr. Harry Hamann · 6 min read