Before understanding drawdown, you should know the real meaning behind the saying “Never Lose Money”. The real difference between an amateur investor and an expert is the understanding of the highlighted term. Most investors focus on how much profit they can earn from a stock, but experienced investors focus on how much they can lose.
At first, “Never Lose Money” seems to be impractical and vague, but once you understand the deeper meaning, your stock market journey becomes smooth and less risky.
“Never Lose Money” in the stock market was popularized by Warren Buffett. He shared two rules:
Rule No. 1: Never Lose Money
Rule No. 2: Never Forget Rule 1
In this blog, we will understand what a drawdown is and why it is important to think differently so that you never lose your money in the stock market.
What is Drawdown?
Dradown means a decline in the invested value from its peak (highest price) to the trough (lowest price). It is measured in percentage.
Fore.g.- If you have invested Rs 100 in a share and the price reaches Rs 120, and from there it falls to Rs 40. Your drawdown will be Rs 120 to Rs 40, and in percentage it will be 80% drawdown.
Many people confuse drawdown and loss. A drawdown is not a loss until the shares are sold. If you don’t sell the shares during the drawdown, it’s just a decline in your investment.
Why The Concept of Drawdown is Important
Many investors in pursuit of high returns forget that stocks with high returns can also cause extreme dawdowns, and this strategy is quite dangerous. Experienced investors don’t look for high returns; instead, they focus on stable earnings and low drawdowns.
Drawdowns are more dangerous than losses, as in losses, you are done after selling your shares, but in drawdowns, there is no fixed timeline for when your capital is going to recover. Your invested value might remain negative for years.
Therefore, the drawdown tells you:
- Level of Investment Risk
- The Worst Case Scenario
- Level of Emotional Stress
Recovery is Harder Than Loss
On of the harshest things about drawdowns is that recovery from drawdowns is harder than losses. The percentage you lose will require a greater percentage to recover. Therefore, a smart approach of less greed and more stability is required to become a successful investor.
Recovery Table:
- A 10% loss requires an 11% gain to recover
- A 20% loss requires a 25% gain
- A 50% loss requires a 100% gain
Why Beginners Struggle
Beginners struggle in the stock market because they operate on greed and fear, and become highly optimistic in the market. The stock market is not a fixed money-earning scheme where you can invest and expect to become wealthy overnight. It’s a market that requires the highest patience and smart strategies.
Avoid these common mistakes:
- Not using stop loss
- Holding a stock for eternity
- Operating on emotions
Two Types of Drawdown
Current Drawdown: How much your investment is down currently.
Maximum Drawdown: The largest drop in investment.
Extent of Stress During Drawdown
We react differently to the percentage of drawdown.
A drawdown of 5-10% is moderately stressful as hopes of recovery are high.
A drawdown of 30-40% becomes extremely painful and results in panic and anxiety.
Final Thoughts
Smart investors are critical thinkers as they compare how much they can earn from an investment and how much they are willing to lose, and set earning targets and stop losses accordingly.
These are the most successful investors in the stock market because they don’t let emotions overpower rationality.
For a better understanding of various stock market concepts and to become a successful and knowledgeable investor, join Strategic Alpha’s “The Conviction Club”. A membership program for those who prioritize logical thinking over emotion-driven decisions.
If you need guidance on how to start your stock market journey, how much capital is enough to begin with, how to do smart investing, or how to take informed stock market decisions, you can join Strategic Alpha’s ‘The Conviction Club’. This is a membership program, especially curated to help investors become aware and knowledgeable about stock market trends, news, and technical aspects, so that they can become their own experts.
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Disclaimer: Strategic Alpha and Suyog Dhavan are not SEBI-registered investment advisor. The content provided is purely for educational purposes and should not be construed as financial or investment advice. Viewers are encouraged to conduct their own research or consult with a SEBI-registered professional before making any investment decisions.
