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Measuring risk: volatility, drawdown, recovery time
· Concept
Fact, law or dataA rule, statute, definition or measured number.
Investors gauge risk by volatility (how much returns swing), maximum drawdown (worst peak-to-trough fall) and recovery time (how long to get back).
See it on the Money & Finance map →How it works
Volatility is the standard deviation of returns; for the S&P 500 it runs about 15–20% a year, so a typical year lands within that many points of the average. Maximum drawdown is the worst case: the S&P 500 fell about 57% from October 2007 to March 2009, and about 86% from 1929 to 1932. Recovery time: the 2007 price peak was regained in March 2013; the 1929 peak only in 1954 (sooner counting dividends). Others include beta and the Sharpe ratio.
Why it matters
Averages hide the path. A plan has to survive the bad stretch, including an investor's cash needs and nerves, not just earn a long-run average.
Think of it like
Drawdown is like vacancy in a downturn: what matters is not average occupancy but how empty the building gets and how long re-leasing takes.
Facts, rules and data
Index price histories (S&P Dow Jones Indices, CRSP data back to 1926) and standard definitions in finance textbooks and the CFA curriculum.
Debates and risks
Volatility treats gains and losses alike and assumes bell-curve returns; real markets have fatter tails, so crashes come more often than such models predict.
Connections (2)
▸Measuring risk: volatility, drawdown, recovery time quantifies the damage of Bull markets, bear markets and correctionsFact, law or data
The connection
A bear market is a fall of 20% or more from a peak; a correction is 10%. Risk measures say how bad each was: depth, length and recovery. The 2020 Covid bear fell about 34% in 33 days and recovered in five months; 2007–09 fell about 57% and took until 2013 to recover.
When and why
Every downturn since 1929; recent cases include 2000–02, 2007–09, 2020 and 2022, which fell about 25% and regained its high in January 2024.
How we know
Index histories from S&P Dow Jones Indices; the 20% threshold is a market convention, not a law.
Debates and risks
Whether past drawdowns predict future ones, and whether price-only measures, ignoring dividends and inflation, misstate recovery times.
▸Diversification and asset allocation lowers Measuring risk: volatility, drawdown, recovery timeMainstream view
The connection
Mixing assets that don't move together lowers volatility. Two assets that each swing 20% a year, held half and half with no correlation, swing only about 14% combined; if perfectly correlated, still 20%. Drawdowns usually shrink too. Diversification cannot remove market-wide risk, only company- and asset-specific risk.
When and why
Markowitz (1952); William Sharpe's 1964 model separated market risk from diversifiable risk; Evans and Archer (1968) measured it with real stocks.
How solid is the link?
Portfolio math, and return histories showing diversified portfolios with shallower drawdowns in crises such as 2008.
Debates and risks
In panics, correlations jump toward one just when protection is needed; how much diversification helps in a true crash is debated.