The Curious Case of Stock Price Drawdowns

In “A Scandal in Bohemia,” master sleuth Sherlock Holmes warns Dr. Watson against forming theories without sufficient evidence; It is a capital offense to theorize before one has data. Insensibly, one begins to twist facts to suit theories, instead of theories to suit facts.”Holmes’s insistence on letting evidence guide us to our conclusions is useful in all matters of intellectual pursuit — including investing.

Inspired by Holmes’ approach, this paper examines a common experience for stock investors — the drawdown. A “drawdown” is the difference between the peak in the price of a stock and its subsequent trough — a recurring occurrence in the stock market. Yet, the prevailing theories about drawdowns and their impact on future returns often overlook critical evidence.

A widely held belief among investors today is that large drawdowns (such as drops of 50% or more) signal poor future returns, suggesting these declines are likely long-lasting. When stock market prices plunge, even seasoned investors feel the psychological pull — regret, fear, doubt — to abandon logic in favor of emotion. In such moments, we instinctively search for narratives to explain our discomfort, often settling on the most familiar one: a steep drawdown must mean that the stock, and the company it represents, are fundamentally broken.

But are drawdowns truly reliable evidence of an impaired investment and poor future returns? Or are they simply unsettling, yet temporary, bumps along the road to recovery? This paper aims to address these questions by letting the facts shape our understanding.

Mathematical Facts

The first set of facts we present is the arithmetic surrounding drawdowns and subsequent stock price recoveries. We begin here because the belief that steep drawdowns signal poor future returns is often rooted in the challenging mathematical path to recovery. For example, if a stock declines 50% in price, it must appreciate 100% just to return to its previous peak.

In Figure 1, we illustrate the appreciation required for a stock to regain its previous peak under various severe drawdown scenarios. Since the scale of recovery is immense, these numbers seem to support the notion that a full recovery will be difficult to achieve. As Holmes cautioned, no matter how compelling a theory may seem, forming it prematurely risks distorting the facts to fit preconceived notions. And in this case, the “math” of recovery is not the “path” of recovery. To gain a more complete understanding of the implications of a significant drawdown, we must look beyond the math and examine the probabilities of recovery suggested by real-world outcomes. Anything less would indeed be “theorizing without data.”

In the following section we analyze historical stock market data to determine whether large drawdowns foretell poor long-term performance, or if they are simply part of the normal volatility investors must endure.

Real World Evidence

To augment our understanding of real-world drawdown and recovery patterns, we tap into an excellent study by Michael Mauboussin and Dan Callahan titled, “Drawdowns and Recoveries: Base Rates for Bottoms and Bounces.” In this study, the authors analyze the peak-to-trough price performance as well as the timing and magnitude of any subsequent recovery for more than 6,500 companies from 1985 to 2024.

This data, shown in Figure 2, is revealing. In many respects, the results run counter to the prevailing investment wisdom (and fear) regarding the long-term impact of large price declines. To illustrate our findings, we highlight that portion of the study assessing the long-term effects of an extremely painful and frightening 70–75% decline in a stock price. The reader can see that 62% of those stocks experienced a full price recovery. The median recovery was 131% of the pre-drawdown peak. This fact bears repeating: nearly two thirds of the stocks fully recovered after a jarring price decline. It’s also worth noting that the median recovery equates to appreciation of 330% to 420% from the low point — suggesting the cost of selling following a drawdown can be substantial.

From this historical analysis, we draw three critical insights that help frame the predictive value of large drawdowns on future returns:

• First, First, significant drawdowns are a common occurrence over the lifecycle of the average stock, i.e., 93% of the stocks in the sample declined by 50% or more at some point. Importantly, both the long-term winners and the ultimate losers tend to suffer substantial drawdowns along the way. This is not exception, but the reality of equity market behavior across the study period.
• Second, the typical peak-to-trough price decline is surprisingly severe. On average, stocks experienced a max drawdown of 80.7% with a median drawdown of 85.4%.[1] Ouch. These are sobering numbers—capable of rattling even the most steadfast investors—and yet they are normal by historical standards.
• Third, steep drawdowns can be followed by powerful recoveries. In many cases, these recoveries see the stocks soundly exceed previous highs. This finding contradicts the assumption that large price declines are synonymous with permanent capital loss.

The empirical evidence is convincing. A steep drawdown has not been a reliable indicator of subpar long-term stock price performance, except arguably in the most extreme cases (e.g., price declines of 90% or more). Instead, the evidence suggests that these drawdowns are a standard characteristic of the stock market journey, common to both the ultimate winners and laggards.

That said, we must remain open to the possibility that the future may diverge from the past. Structural changes, unforeseen risks, or disruptive innovations could alter these historical base rates. Yet, we derive comfort in one enduring force: human nature. The hard-wired psychological drivers of most market inefficiencies — fear, greed, bias — are unlikely to change.

Immutable psychological traits aside, we would be remiss not to consider the growing role of artificial intelligence in moderating some of these human tendencies. Artificial intelligence may increasingly serve as a counterbalance to the emotional extremes that have historically shaped markets. We’ll be watching closely.

Our Experience

The historical market data is consistent with our own experience as long-term holders of stocks. In Figure 3, we list the 20 stocks with the largest total price gain in the DGI Mid Cap Growth and DGI Small Cap Growth composites since the inception of DGI. We also highlight the maximum drawdowns those stocks experienced over our holding period, which ranges from 6 to 28 years for this sample.

Despite generating returns that exceed the designated equity benchmark indexes for each composite over the since-inception period, each stock listed has experienced at least one steep price decline along the way.

Had we adopted the conventional wisdom regarding the predictive power of drawdowns, we likely would have abandoned many, if not all, of our most prolific investments.

At this point, we believe we have gathered enough evidence to offer a defensible theory: steep price declines (except at the extreme) are not a reliable indicator of poor stock performance or permanent capital loss. This means that absent prescient trading capabilities, investors are obliged to suffer these teeth-rattling, temporary price declines to capture the full benefit of the outsized investment returns offered by big winning stocks.

Investment Implications

If both big winners and big losers are prone to steep price drawdowns, then it is imperative investors minimize emotional theorizing during breathtaking drawdowns and instead adopt a discipline that has proven effective at limiting the potential of a permanent loss of capital. We believe the cornerstone of such a strategy must be firmly grounded in price/value relationships, backed up by thorough investment research—including an assessment of business value that is independent of market pricing. A focus on the price/value relationship helps the investor gauge whether a selloff is likely to represent a temporary, rather than permanent, impairment of equity value.

We can illustrate this point with a simple example. Imagine there are two companies, AAA Corp. and ZZZ Corp, where each of their stocks is currently trading at $100 per share. We estimate the intrinsic value (“IV”) of AAA Corp. stock at approximately $100 per share. Similarly, we peg the IV of ZZZ Corp. at $40 per share. Subsequent to our analysis, both stocks decline 50% to $50 per share with no change to the fundamental outlook.

The price/value relationship for AAA Corp. is now extremely attractive as the stock is trading at a 50% discount to the underlying value of the business ($50 stock price vs $100 IV.) A full recovery in this case is highly likely. In contrast, ZZZ Corp. stock is still trading at a price above its assessed value ($50 stock price vs $40 IV) suggesting a full recovery will be difficult absent a material improvement in the value-creating potential of the business. We base these conclusions on the fact that stock prices predictably converge with the IV of the business over time. These dynamics are illustrated in Figure 4.

As we detailed above, such short-term dislocations between stock prices and the value of the underlying business are common.Staying anchored in the price/value relationship reduces the chances that investors will be swayed by arbitrary, albeit psychically painful, price movements.

Assuming our valuation work is sound, it provides an understanding of the basis of the respective price declines. After the price decline, AAA Corp. stock would represent an opportunity to initiate or add to a position with the potential for outsized future gains. On the other hand, ZZZ Corp. stock is still overvalued based on our analysis of the intrinsic value of the business.

This is why assessing and honoring the price/value relationship lies at the core of our research effort. Our process begins with developing a comprehensive understanding of each business and the markets in which it competes. We leverage this knowledge to develop a reasonable estimate of the long-term value creating potential of the business. This focus on long-term value affords us the freedom to capitalize on (or simply ignore) short-term price movements.

Of course, no strategy avails us with perfect foresight. Knowledge is valuable, not infallible. Attempts to predict an uncertain future find a way to make an investor look foolish at times. Fortunately, success does not require that we be right 100% of the time. It does, however, demand the courage to follow the evidence when stocks are unjustly punished by the market.

Conclusion

Too often, investors abandon stock positions not due to new facts but innate fears. The sting of a steep stock price drawdown presents a particularly difficult situation as it often triggers hasty, emotionally charged impulses that can lead investors to prematurely sell a position. Yet, investors must resist the urge to let price movements alone dictate their thoughts and actions. Steep drawdowns certainly feel disastrous, but it’s important to recognize that these price declines are not reliable predictors of poor future returns. Major drawdowns are, in fact, a natural part of owning top-performing stocks and must be endured on the path to achieving strong long-term returns

As always, we value your feedback and thank you for your continued patience.