Drawdown and volatility: two ways to measure risk

"Risk" is one of the most used words in investing and one of the least defined. For most people it simply means the chance of losing money. Professionals use more precise measures, and two of them are easy to understand without any statistics course: volatility and drawdown. This guide explains both, shows the arithmetic of losses and recoveries, and explains why the numbers can mislead on a market where many shares trade rarely.

Volatility: how much a price moves around

Volatility measures how widely an investment's returns swing around their average. A deposit that pays the same rate every month has almost no volatility. A share whose price rises 8% one month and falls 6% the next has a lot.

The usual measure is the standard deviation of returns. In plain words: take the monthly returns over a period, find their average, and measure how far a typical month lands from that average. A larger number means wider swings.

An illustrative comparison with round numbers. Two investments both average 1% a month over a year:

• Investment A returns between 0% and 2% every month.
• Investment B returns +9% in some months and -7% in others.

The average is the same, but living with B feels very different. In a month when you need the money, B may be well below where it started. Volatility captures that difference.

Volatility is usually quoted on a yearly basis. A rough conversion from monthly to yearly multiplies the monthly figure by the square root of 12, about 3.5. So a monthly standard deviation of 4% corresponds to about 14% a year.

What volatility does not tell you

Volatility treats rises and falls the same way, though investors only mind the falls. It also assumes that the past pattern of swings is a fair guide to the future. A company that has been calm for years can still collapse after one piece of bad news. Treat volatility as a description of the past, not a promise.

Drawdown: how far you fell from the top

A drawdown is the fall from a previous peak to a later low, measured in percent. If your portfolio reached 10,000,000 soʻm, then dropped to 7,000,000 soʻm before recovering, that was a 30% drawdown.

The maximum drawdown is the largest such fall over a period. It answers a question most investors understand at once: what is the worst loss someone would have suffered if they had bought at the worst moment and sold at the worst moment in that period?

Drawdown has a second part that matters as much: time to recover. A 30% fall that recovers in six months is a very different experience from one that takes six years.

The arithmetic of losses

Losses and gains are not symmetric. After a fall, you need a larger percentage gain to get back to where you were, because the gain applies to a smaller amount.

• After a 10% loss you need an 11% gain to recover.
• After a 20% loss you need 25%.
• After a 30% loss you need about 43%.
• After a 50% loss you need 100%.
• After a 75% loss you need 300%.

The formula is simple: the gain needed is the loss divided by what is left. After a 50% loss, 50 ÷ 50 = 100%. This is why limiting large losses matters so much over a lifetime of investing, and why the size of a single position deserves attention. See position sizing.

Why thin trading can hide risk

Volatility and drawdown are calculated from prices. On the Tashkent Stock Exchange (UZSE), many shares do not trade every day. When a share has no trade, its last price simply stays on the screen. That creates two illusions.

Smooth-looking prices. A share that trades once a week shows long flat stretches followed by jumps. Its measured volatility can look low because most days show no change at all, even though the real price at which you could sell may have moved a lot.

Hidden drawdowns. If no one trades during a bad period, the chart does not show how low a seller would really have had to go. The first trade after a long pause can reveal a large move all at once.

For thinly traded shares, look at the number of days with trades and the volume before trusting any risk figure. The liquidity risk guide shows what to check.

Portfolio risk is not the sum of its parts

A portfolio of several investments usually swings less than its parts, because they do not all fall at the same time. That is the idea behind diversification. The effect is weaker when holdings depend on the same driver, such as several banks, or several companies whose prices are set by the same regulator. In a broad market fall, many shares drop together and diversification between them helps less than in calm times, while deposits and short government bonds often behave differently. Diversification and risk explains the idea in more detail.

Using these measures in practice

1. Look at the worst case first. Before you buy, check the largest fall in the investment's history that you can see. Ask whether you could hold on through a fall of that size in your own portfolio.
2. Check the recovery time. A long recovery matters if you may need the money within that time.
3. Compare like with like. Compare volatility and drawdown over the same period and on the same data frequency, daily with daily and monthly with monthly.
4. Adjust for liquidity. For shares that trade rarely, assume the real risk is higher than the numbers show.
5. Match risk to your horizon. Money for next year should not sit in something that can fall 40% and take years to recover.

Finmind's public stocks pages show each UZSE share's price history, so you can see its past falls and recoveries yourself. The paid Risk feature calculates volatility, value at risk, maximum drawdown, beta and concentration for your own portfolio and labels its methodology.

This article is for education only and is not investment advice. Investing in securities involves risk, including the loss of money you invest.