Drawdown budgeting: setting a maximum drawdown and backing out the equity share

What you will learn

• How a drawdown budget differs from a volatility target and why it is easier to live with
• Which historical worst cases to use for equities and defensive assets
• The formula that backs out the equity share from a drawdown budget
• How to add a safety margin and translate the result into euros

Explanation

A drawdown is the fall from a previous peak to the following low, measured in percent of the peak. Drawdown and recovery maths for trading accounts was covered in the course Risk & Trade Management; here we apply the idea to allocation. A drawdown budget is a written statement such as "I accept a peak-to-trough loss of at most 25% of the portfolio, about €75,000 on €300,000". It is more useful than a volatility target because people feel losses in euros from a peak.

The method has four steps. (1) Write the budget in percent and euros. (2) Assign a worst-case loss to each building block, based on historical worst cases. Approximate historical observations: broad global equity indices fell by roughly half in 2000–2003 and by a little more than half in 2007–2009 in US-dollar terms; the German DAX fell by roughly 70% in 2000–2003; broad euro government bond indices fell by more than 10% in 2022. These are observations, not limits. (3) Back out the equity share with the formula below. (4) Apply a safety margin and round down.

With an equity worst case E and a defensive-block worst case D occurring at the same time, the portfolio drawdown is x × E + (1 − x) × D, where x is the equity share. Setting this equal to the budget B and solving gives:

x = (B − D) ÷ (E − D)

If the defensive block is assumed not to lose at all (D = 0), the formula collapses to x = B ÷ E. Rebalancing during the fall and dividends change the result slightly, but as a design rule the formula is sound. The safety margin matters because the next crisis may be deeper than the deepest observed one; adding five to ten points to the equity worst case is a common practice.

Worked example

Hypothetical example: a €300,000 portfolio and a maximum-drawdown budget of 25% (€75,000). Assumed worst cases: global equities −55%, defensive block (short-duration euro government bonds and money market) −10% at the same time. Fees, spreads and taxes excluded; the assumptions are illustrative, not forecasts.

Step 1 – defensive block loses nothing. x = 25% ÷ 55% ≈ 45.5%. Equities ≈ €136,000.

Step 2 – defensive block loses 10% simultaneously. x = (25% − 10%) ÷ (55% − 10%) = 15 ÷ 45 ≈ 33.3%. Equities ≈ €100,000. The 2022-type regime, where bonds fell with stocks, cuts the allowed equity share by about 12 points.

Step 3 – safety margin. Raise the equity worst case to 60%. With D = 0: x = 25 ÷ 60 ≈ 41.7%. With D = 10%: x = 15 ÷ 50 = 30%.

Step 4 – check. At 45% equity, E = 55%, D = 0: loss = 0.45 × 55% = 24.75% ≈ €74,250, inside budget. An investor who wants to survive the bond-and-stock regime would choose 30–35% and write down why.

Note the trade-off with lesson 3: cutting the equity share from 45% to 33% also lowers the expected return by roughly 0.12 × (equity return − bond return), for example 0.12 × 2.8% ≈ 0.34 percentage points per year with the earlier assumptions. The drawdown budget is a choice about this trade.

Common mistake

Practice activity

An investor has €180,000 and writes a maximum drawdown of 20%. Assumed worst cases: equities −50%, gold −30%, short-term bonds −5%, all at the same time. The investor wants 10% in gold. Calculate the maximum equity share, the resulting bond share, and the euro loss in the worst case. Then recalculate with an equity worst case of 60%.

Key takeaways

• Write the drawdown budget first, in percent and euros, before looking at expected returns.
• Equity share = (budget − defensive worst case) ÷ (equity worst case − defensive worst case).
• Assuming the defensive block also loses, as in 2022, cuts the allowed equity share by roughly a quarter.
• Add a safety margin to the historical worst case; the future is not bounded by the past.

Next step

Once the core allocation fits the risk and drawdown budgets, the next lesson shows how to add satellite positions without silently breaking those budgets, using a tracking-error budget.