Drawdown

Suppose you start with $10,000. Over a year the account climbs to $12,000, slides back to $9,600, and then finishes at $13,000. Your return for the year is a very respectable +30%. Your maximum drawdown is 20% — that’s the fall from the $12,000 high down to $9,600.

Both numbers are true, and they’re answering different questions. The return tells you where the strategy finished. The drawdown tells you what it felt like to hold, and that’s the one that predicts whether you’ll still be holding it later. Almost everyone who abandons a perfectly good strategy does it near the bottom of a drawdown — which is, of course, exactly the worst possible moment.

So when you’re comparing two strategies with similar returns, the one with the shallower drawdown is usually the better one to own. Not because the maths says so, but because it’s the one you’ll actually stay invested in.

A useful habit: before you put real money behind a strategy, look at its worst drawdown and ask yourself honestly whether you’d have sat through it. If the answer is no, size the position smaller until the answer is yes.