Portfolio & RiskExplainer
What are volatility and drawdowns, and why do they matter to investors?
Volatility measures how much returns swing; a drawdown is the fall from a peak. See both with code-computed examples and a real 2020 market drop.
Quick answer
Volatility describes how widely an investment's returns swing around their average, often measured by standard deviation. A drawdown is a decline from a previous peak, usually shown as a percentage. Big drawdowns need even bigger gains to recover: a 50% fall needs a 100% rise.
Key points
- A common measure of volatility is the standard deviation of returns — how spread out returns are around their average.
- A drawdown is a loss from a previous peak; the worst peak-to-valley drawdown is the largest such fall over a period.
- Two paths with the same 5% average yearly return can end at different values if one swings more.
- After peaking on Feb. 19, 2020, the S&P 500 fell to 66% of that peak by March 23, a drawdown of about 34%.
- A fall of 34% needs a gain of about 51.5% to get back to the old high.
What is volatility?#
Volatility is how much an investment's value or returns move up and down. An economic letter from the Federal Reserve Bank of San Francisco explains that one commonly used measure is the standard deviation of returns, which measures the dispersion of returns from an average[1]. Standard deviation is a statistic: a small number means returns stay close to their average; a large number means they often land far above or below it.
Volatility is not the same as losing money. A volatile investment can rise sharply too. But large swings mean a wider range of possible outcomes in any given period, and that matters when you might need the money at a bad moment. The same letter notes that for many investors, volatility means portfolio losses[1].
Worked example
Worked example: same average return, different volatility
Two made-up four-year paths for $10,000. Both average +5% a year. The bumpy path alternates +25% and −15%.
| Measure | Steady path | Bumpy path |
|---|---|---|
| Yearly returns | +5%, +5%, +5%, +5% | +25%, −15%, +25%, −15% |
| Average yearly return | 5.00% | 5.00% |
| Standard deviation of yearly returns | 0.00% | 20.00% |
| Value after 4 years | $12,155.06 | $11,289.06 |
| Largest fall from a peak | 0.00% | 15.00% |
Figures computed in code from the stated inputs; rounded to the nearest cent or tenth.
Two paths with the same average return
What is a drawdown?#
A drawdown measures a fall from a high point. U.S. commodity-pool regulations give two useful definitions. A draw-down means losses experienced by a pool or account over a specified period. The worst peak-to-valley draw-down means the greatest cumulative percentage decline in month-end net asset value during any period before the earlier value is regained[2].
In plain terms: find the highest value so far (the peak), find the lowest value after it before the peak is beaten (the valley), and express the fall as a percentage of the peak. Those rules come from the Commodity Futures Trading Commission (CFTC) and apply to certain funds in the U.S.; rules differ by country, but the same peak-to-valley idea is used widely to describe any portfolio.
Why does a big drop need an even bigger gain to recover?#
Because the recovery starts from a smaller balance. Lose 50% of $10,000 and you have $5,000; getting back to $10,000 then needs a 100% gain. The deeper the fall, the steeper the climb.
| Drawdown from peak | Gain needed to recover |
|---|---|
| 10% drawdown | 11.11% |
| 20% drawdown | 25.00% |
| 25% drawdown | 33.33% |
| 34% drawdown | 51.52% |
| 50% drawdown | 100.00% |
Computed as 1 ÷ (1 − drawdown) − 1 in scratch/writer-portfolio/calc_volatility.py.
This arithmetic is why a smoother path can end higher than a bumpy one with the same average, as in the example above. It is also why your time horizon matters: a deep drawdown just before you need the money may not leave time to recover.
What did a real market drawdown look like?#
Early 2020 gives a clear, recent case. Researchers at the Federal Reserve Bank of St. Louis wrote that after peaking on Feb. 19, 2020, the S&P 500 dropped to 66% of its peak by March 23[3]. That is a drawdown of about 34% in 33 days. The S&P 500 is an index that includes 500 leading U.S. companies[4]; see stock market indexes explained.
The early-2020 stock market fall
The Federal Reserve's May 2020 Financial Stability Report described equity prices plunging as concern over the outbreak grew, and noted that a measure of expected 30-day equity volatility implied by option prices surged to a record daily reading in mid-March[5]. A year after the peak, the same St. Louis Fed article reports the S&P 500 at 115% of its pre-crisis level[3].
How can you see an investment's volatility before you buy?#
For U.S. mutual funds and ETFs, the prospectus is a good place to look. SEC Form N-1A requires a bar chart of the fund's annual total returns for each of the last 10 calendar years (or its life, if shorter), plus the fund's highest and lowest return for a quarter in that period[7]. The form says this information provides some indication of the risks of investing in the fund by showing changes in performance from year to year[7].
You may also hear about the VIX, a widely quoted volatility index. FINRA explains that the VIX is not based on actual price moves but reflects an expectation of stock market volatility over the next 30 days, as implied by S&P 500 index option prices[8]. FINRA adds that products tracking volatility generally aren't designed as buy-and-hold investments and can quickly lose some or all of their value[8].
For fund documents in general, our note on how to read a fund prospectus shows where the risk sections sit.
How can beginners live with volatility?#
FINRA acknowledges that volatile markets can inspire feelings of fear and anxiety among investors, and that surges and selloffs can happen for many reasons, from inflation fears to global events[9]. You cannot control those reasons, but you can control how exposed you are and how you respond.
- Match risk to the goal. Money needed soon has little time to recover from a drawdown. See risk tolerance and time horizon.
- Spread the risk. FINRA recommends diversifying across, and within, the major asset classes[9]. See diversification explained.
- Decide in advance. A written mix and a rebalancing rule reduce the temptation to act on fear in the middle of a fall.
What mistakes do beginners make?#
Confusing volatility with permanent loss
A price that falls and recovers is volatile; a loss becomes permanent when you sell at the low or the investment never recovers. Know which one you are looking at.
Forgetting the recovery arithmetic
A 50% fall needs a 100% gain to break even. Judge how deep a fall you could sit through using the gain needed, not just the size of the drop.
Reading average returns without the swings
Two investments with the same average return can end at different values if one is much bumpier. Look at the range of yearly returns too.
Treating volatility products as long-term holdings
FINRA warns that volatility-linked products generally aren't designed to be bought and held and can quickly lose some or all of their value.
What else do beginners ask?#
Is high volatility always bad?
Not by itself. Volatility means returns swing widely in both directions. It becomes a problem when you might need the money during a downswing or when the swings push you to sell at a low.
What is maximum drawdown?
It is the largest percentage fall from a peak to a later low before the peak is regained. U.S. commodity-pool rules call it the worst peak-to-valley draw-down[2].
How is volatility measured?
How long do drawdowns last?
There is no fixed length. After the early-2020 fall, the S&P 500 stood at 115% of its old peak one year after that peak[3], but one case does not predict the next. No source can tell you in advance how long a future drawdown will last.
What is the bottom line?#
Volatility tells you how much an investment's returns swing; a drawdown tells you how far it has fallen from its high. Both are normal for growth investments, and both matter more the sooner you need the money. Remember the recovery arithmetic — deep falls need much larger gains to repair — and check a fund's yearly returns and worst quarter before you buy. Then size your risk so that a bad year is uncomfortable, not ruinous.
Sources
Numbers in brackets in the text point here. Grade A = primary source (regulator, statistics agency, law or official document).
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