By the end Explain why avoiding large drawdowns dominates capturing large gains.
Risk +16
Quant +4
Compounding requires surviving. That sounds obvious and is routinely ignored, because the arithmetic of recovery is unintuitive and the strategies that produce large drawdowns often look excellent right up until they do.
Recovery arithmetic
Drawdown
Gain to recover
At 10% a year, time to recover
−20%
+25%
About 2.3 years
−35%
+54%
About 4.5 years
−50%
+100%
About 7.3 years
−70%
+233%
About 12.6 years
Ruin risk is the limiting case. A strategy with a positive expected return but a small chance of total loss per period will, given enough periods, produce total loss with near certainty. Leverage is the most common route: it raises returns proportionally and raises ruin probability disproportionately, because a large enough adverse move ends the sequence entirely.
Why repeated small ruin risks compound
P(survive n periods) = (1 − p)ⁿ
A 2% chance of ruin per period leaves about a 60% survival probability over 25 periods and about 13% over 100. A small per-period risk becomes near-certain failure given enough repetitions.
Common belief
"I can recover from any loss if I keep trading."
What is actually true
Recovery requires both capital and time, and each large loss consumes disproportionately more of both. Traders who lose 70% and attempt to recover it quickly typically increase size, which raises ruin probability at precisely the point they can least afford it.
Glossary
Drawdown
The fall from a peak to a trough, expressed as a percentage of the peak.
Ruin
A loss large enough that recovery is not practically possible.
Leverage
Using borrowed capital. It magnifies both returns and the probability of ruin.
Check your understanding
0 of 3 answered
Pass mark 70%: at least 3 of 3 correct.
Challenge — Model your own recovery
Take a A$200,000 portfolio. Compute its value after drawdowns of 25%, 45% and 65%, the gain required to recover each, and the approximate years to recover at 8% annually. Then state the maximum drawdown you would accept and why.
What a good answer contains
Computes values and recovery percentages correctly for all three
Estimates recovery time using the stated return rate
States a personal maximum with reasoning rather than an arbitrary number
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