Risk, volatility and drawdowns: what to expect
Investing in stocks means living through drops. Knowing how big they've been, how long they took to recover and how much you can take is the best protection.
In investing, risk usually means two things: that your investment's value swings a lot along the way (volatility) and that you lose money permanently. Both matter, but they're not the same: a drop that recovers is uncomfortable; a permanent loss is what you need to avoid.
Volatility
Volatility measures how much the price moves. CETES barely move; an S&P 500 ETF moves quite a bit; a small tech stock or a cryptocurrency moves a lot. In exchange for accepting more volatility, investors expect more return over the long term; otherwise, nobody would take the risk.
| Investment | Typical volatility | Long-term expected return |
|---|---|---|
| CETES and interest accounts | Very low | Low, near inflation or a bit more |
| Long-term bonds | Medium | Moderate |
| Broad stock ETF | High | Higher, with very bad years |
| A single stock | Very high | Very uncertain: it can multiply or lose almost everything |
Drops are part of the road
The S&P 500's history shows that sharp drops happen fairly often. Within a normal year, it's common to see a decline of 10% or more at some point, even if the year ends positive. And every few years a big drop arrives:
| Episode | S&P 500 drop (peak to trough) | Time to recover the peak |
|---|---|---|
| Financial crisis 2007-2009 | ≈ −57% | About 5½ years |
| Pandemic 2020 | ≈ −34% in one month | About 5 months |
| Inflation and rates 2022 | ≈ −25% | About 2 years |
Each recovery took a different time and nothing guarantees the next will be the same. But whoever sold at the worst moment turned a temporary drop into a permanent loss.
The math of losses
Losses weigh more than gains: if you lose 50%, you need to gain 100% to get back to where you were. If you lose 20%, you need 25%; if you lose 30%, almost 43%. That's why controlling the size of drops matters as much as seeking returns.
Gain needed to recover = 1 ÷ (1 − loss) − 1
Types of risk
- Market: the whole market falls (recessions, crises).
- Specific: one company does badly on its own; diversification reduces it.
- Interest rate and inflation: they mainly affect bonds and fixed income.
- Currency: if your investments are in another currency.
- Liquidity: not being able to sell quickly at a reasonable price.
- Concentration: having too much in one thing.
- Behavioral: your own decisions in moments of fear or euphoria; often the most expensive.
Your risk tolerance and risk capacity
Tolerance is emotional: how anxious you get watching your investment fall. Capacity is practical: how much you can lose without hurting your goals (it depends on your time frame, your emergency fund and your income stability). Your portfolio should respect the lower of the two.
Test what you learned
1. If an investment falls 50%, how much does it need to rise to recover its value?
- 50%
- 75%
- 100%
Show the answer
100%. To go from 50 back to 100 you have to double: +100%.
2. Which type of risk is reduced by diversifying across many companies?
- Each company's specific risk
- The risk that the whole market falls
- Inflation risk
Show the answer
Each company's specific risk. What happens to one company weighs little in a broad portfolio.
3. What is risk capacity?
- How anxious a drop makes you
- How much you can lose without hurting your goals
- How many stocks you own
Show the answer
How much you can lose without hurting your goals. It depends on your time frame, your emergency fund and your income.
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Everything in this section is educational: it explains how investing works, it doesn't tell you what to buy.