The Hidden Cost of Drawdowns: How They Undermine Your Compounding Growth

Compounding is often hailed as the eighth wonder of the world. But what happens when market downturns threaten to dismantle years of growth? Drawdowns are not just temporary setbacks—they can cripple your portfolio’s ability to recover. This blog explores how drawdowns disrupt growth, why recovering from losses is so difficult, and strategies to protect your portfolio.

How Drawdowns Affect Compounding

Compounding is a powerful force in investing, enabling your portfolio to grow exponentially over time. However, compounding requires uninterrupted growth, and sharp drops in value—called drawdowns—can derail years of progress.

This analysis explores the impact of drawdowns of -20%, -30%, -40%, -50%, and -60% on portfolios with initial CAGRs (Compound Annual Growth Rates) of 5%, 10%, 15%, 20%, and 25%.

It assumes the CAGRs are calculated over five years, with drawdowns occurring in the sixth year.

Key Findings

The Severe Impact of Larger Losses:

• At a -60% drawdown, even the highest-growth portfolio (initially 25% CAGR) sees its growth rate shrink to below 5% per year.

Lower Growth Rates Suffer the Most:

• A portfolio with an initial CAGR of 5% falls into negative growth after just a -30% drawdown. Losses outpace gains, making recovery incredibly difficult without extraordinary performance.

The Compounding Gap Widens Over Time:

• As drawdowns deepen, the gap between the initial CAGR (dotted lines) and the adjusted CAGR widens.

• The red line at 0% CAGR marks the tipping point where growth turns negative, highlighting how quickly compounding can be disrupted.

Recovery Rates: The Uphill Battle After a Drawdown

Recovering from losses is like climbing a steep mountain—it requires much more effort than the fall. Here’s why recovery is so challenging and what makes drawdowns particularly dangerous:

The Recovery Challenge

To recover from a drawdown, a portfolio must achieve significantly larger gains than the initial losses to return to its original value:

• A 20% loss requires a 25% gain to recover

• A 50% loss requires a 100% gain to recover

• A 60% loss requires a staggering 150% gain to recover

Why Recovery Is So Hard

1. Uneven Losses: The deeper the drawdown, the harder it is to regain lost ground.

2. Withdrawals Deepen the Losses: Selling investments during a downturn locks in losses and makes recovery even harder.

Visualizing the Recovery Challenge

For example, if a $10,000 portfolio drops by 50%, recovering to the original value requires a 100% gain. This demonstrates the critical need to minimize drawdowns to preserve growth.

The exponential rise in required recovery rates underscores the importance of minimizing drawdowns. For example:

• A -10% drawdown requires an 11% recovery.

• A -50% drawdown requires a 100% recovery.

• A -90% drawdown requires an astonishing 900% recovery.

Key Insights

Portfolios with Low Initial CAGRs Face the Greatest Challenges: A portfolio growing at 5% CAGR faces severe challenges after moderate losses. For example, after a -40% drawdown, its adjusted CAGR turns negative (-4.35%), making recovery incredibly difficult without extraordinary growth.

High-Growth Portfolios Are Resilient, But Not Invincible: Even a 25% CAGR portfolio struggles after extreme drawdowns. A -60% drawdown reduces its CAGR to just 3.38%, requiring substantial gains to regain momentum.

Recovery Timeframes Increase Dramatically: Larger drawdowns require higher recovery rates and extend the recovery timeline. For example, a -50% drawdown at 10% CAGR would take over seven years to fully recover.

Protecting Against Drawdowns: The Path to Stable Compounding

To minimize the impact of drawdowns and preserve compounding, investors should adopt risk management strategies:

1. Diversification: Spread investments across asset classes and geographies to reduce exposure to individual market shocks.

2. Non-Correlated Assets: Include assets like government bonds, commodities, or currencies that do not generally trend similarly to the broader market.

3. Rebalancing: Periodically adjust portfolios to ensure risk remains aligned with investment goals.

Practical Tips for Investors

• Consider adding alternatives like real estate, gold or currencies, which frequently exhibit different performance characteristics compared to stocks.

• Consult a financial advisor to design a strategy tailored to your goals.

Final Takeaways

• Drawdowns hurt compounding disproportionately, making recovery increasingly difficult as losses deepen.

• Recovery requires higher returns than the original losses, which can take years to achieve.

• Risk management through diversification, non-correlated assets, and rebalancing is essential to protect growth.

Understanding the impact of drawdowns is crucial for preserving long-term compounding. By adopting a sensible risk management framework, investors can better navigate market downturns and protect their portfolios, ensuring a more sustainable growth trajectory.