Compounding, Drawdowns, Averaging Down, and Portfolio Risk
Summary
This essay uses hypothetical investment examples to explain how returns compound asymmetrically: a loss requires a larger percentage gain to recover, and alternating gains and losses can produce a modest long-run result despite large individual moves. It also illustrates how small daily gains or high annual returns compound rapidly, while noting that sustaining such rates is difficult. Other examples cover averaging down, reducing a position after gains, and the bounded upside and potentially severe losses of short selling.
The final sections advocate diversification, capital preservation, lower volatility, and long holding periods. A simple mix of a fixed-return asset and a risky asset is used to introduce a CPPI-like approach. The examples are illustrative rather than empirical evidence or a complete investment framework: assumptions are simplified, and the discussion does not address taxes, transaction costs, changing returns, or the risks of treating past or target returns as dependable. The essay also makes a speculative claim about future money supply and currency systems without supporting analysis.
Key ideas
- Percentage losses and gains compound asymmetrically, so recovering from a drawdown takes a larger gain than the loss percentage.
- Alternating gains and losses can reduce compounded growth substantially compared with the size of individual returns.
- Averaging down changes the position's weighted average cost, but it does not remove the risk of further declines.
- Short selling has capped gains when the asset price cannot fall below zero, while losses can continue as prices rise.
- Diversification and lower volatility are presented as ways to support capital preservation and long-term compounding.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.