Too embarrassed to ask: what is a drawdown?

Drawdowns are an unfortunate part of an investor’s life. But what exactly is a drawdown?

Investing involves taking risks. When you put your money into a savings account in the bank, you can be confident that you’ll have the same amount there the next time you go to check on it. 

Investing isn’t like that. If you invest in shares, property, or any other financial asset, then the value of that asset can go down as well as up. 

If you invest your money in the stockmarket today, then it’s quite possible that you might come back next week, or next month, and find that you have less than you started with.

So why invest? Because in the long run – say, over a decade or more – history suggests that your money will almost certainly grow faster than if you had just left it in cash. The journey might be bumpier, with more ups and downs along the way, but you’ll end up in a much better destination.

However, that can mean navigating some scary moments. For example, during the coronavirus outbreak in 2020, some major stockmarkets lost as much as a third of their value in just a few weeks. This is what investors call a “drawdown” – that is, the amount an investment falls from peak to trough in a given time period.

Drawdowns are part of an investor’s life. Unless you need to pull all of your money out at the bottom of the market – what’s known as crystallising your loss – then over time, your portfolio will probably recover. 

However, it can be useful to get an idea of what a typical drawdown might look like for a given asset class or investment, so that you can understand how volatile it is likely to be. 

If you know what to expect, then you can make sure that your appetite for risk and your portfolio’s make-up are aligned, which should help you to avoid being panicked by any particularly nasty drawdowns. 

One way to minimise likely drawdowns and keep your portfolio’s volatility to a level you are comfortable with, is to diversify across different asset classes.

Historically, equities are the most volatile mainstream asset class – although cryptocurrencies take volatility to a whole new level – while bonds are less volatile. 

To learn more about diversification, subscribe to MoneyWeek magazine.

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