Navigating Market Drawdowns: Lessons from History

A ‘market drawdown’ is the peak to trough performance of a market. Drawdowns can occur for a number of reasons including a changing economic outlook, rising geopolitical tensions or unexpected global events. These market falls can cause investors to panic, a word named after the Greek God Pan, known for causing terror. Market drawdowns can feel scary when they are happening, but they actually occur frequently. Since 1965, the S&P 500 Index has fallen 10% or more on 32 occasions, averaging a fall of that magnitude or more roughly once every two years.

While equity markets typically rise over the long-term, they do not move in a straight line. Corrections are a natural part of investing - and one that investors are all too quick to forget when markets are rising. And even when markets fall they do not always define the performance over a calendar year. The graph below shows the maximum S&P 500 Index drawdowns each year since 1995 and the overall return for the year. Despite average intra-year drops of -15%, annual returns were positive in 22 out of 30 years.

Figure 1: S&P 500 Index declines during the calendar year vs the return in the calendar year

Source: Refinitv, M&G Wealth Investments, 10.04.2025, price returns in USD. Performance data from 1st January 1995 to 10th April 2025. Past performance is not a reliable indicator of future returns.

Market drawdowns can cause unease among investors, causing some to sell their investments as markets fall. The actions of these investors represent opportunity for others. Ben Graham is seen by many as the father of value investing and was Warren Buffett’s mentor. He notes that the market is one of the only places people feel obliged to sell when prices have fallen. If you saw a 20% discount on some trainers you wanted, would you be more inclined to buy them? Of course you would. But when the market falls 20% people don’t want to buy; they instead want to sell.

If we look at the recovery of the S&P 500 Index after a 10%+ drawdown, history has shown us that the best decision for investors is to buy or remain invested. Even if an individual invested at the peak before a market fall, their returns would on average be positive after a little over a year.  

Figure 2: Average returns of the S&P 500 Index from the peak or trough of a 10%+ market fall

Source: Refinitv, M&G Wealth Investments, 04.04.2025, price returns in USD. Data from 1st January 1964 to 31st March 2025. Past performance is not a reliable indicator of future returns.

What can be done to reduce the impact of equity market drawdowns?

One way to avoid large falls in any single market is to hold a diversified portfolio. If assets in a portfolio don’t all move in the same direction, then parts of the portfolio can provide protection when other assets fall. Diversification can come from holding different asset classes such as equities, bonds and alternatives. It can also come from within each asset class--for example holding equities across different regions can diversify portfolios even further.

We looked at the behaviour of a 60% global equity and 40% global bond portfolio versus being fully invested in US equities as represented by the S&P 500 Index over 17 periods where the S&P 500 Index fell 10% or more. With the multi-asset portfolio, the investor would have experienced only 60% of the market fall. As investors sell their equity investments, they will move into more defensive asset classes such as government bonds. A portfolio with an allocation to government bonds can therefore benefit from investors moving from equities into safer asset classes.  

Figure 3: Average portfolio fall when the S&P 500 Index has fallen 10% of more since June 1990

Source: Refinitv, M&G Wealth Investments, 04.04.2025, price returns in GBP. Data from 1st June 1990 to 31st March 2025. Past performance is not a reliable indicator of future returns. Global equities represented by MSCI AC World index and global bonds represented by Bloomberg Global Aggregate GBP Hedged index.

Holding a diversified portfolio can smooth the investment journey for many investors. We have only shown a portfolio of equities and bonds above. However, investors could smooth their investment journey even more by holding alternative asset classes such as infrastructure, property and absolute return funds. These asset classes have the ability to perform well when inflation rises.

Some investors choose to move into cash before a market falls and then invest back into a multi-asset portfolio just before the market starts to rise again. Many call this strategy timing the market. So how easy is it to do this?

We looked at the monthly returns of a multi-asset portfolio invested 60% in US equities and 40% in US government bonds going back to 1929. We also gathered monthly returns for cash[1]. We then created 100 scenarios based on these historic returns over a 500 month period. We found that in order to outperform a multi-asset portfolio, an investor would need to make the correct choice between holding cash or investing in a multi-asset portfolio in 59% of the months.  

At first glance this sounds like a reasonable feat. Well, the best hedge fund managers hope to be right 55% of the time. Even Roger Federer only won 54% of his points. So in order to make the right decision between being invested in cash or a multi-asset portfolio each month, you would probably need to be the best hedge fund manager in the world or have a win rate better than Roger Federer! We therefore think instead of moving in and out of cash, it is better to stay invested in a diversified multi-asset portfolio.

This year, we have seen the S&P 500 Index fall over 10% which is a common event when you look back through history. But history also tells us that when a 10% fall occurs, the best course of action is to stay invested. And for many investors, holding diversified multi-asset portfolios can dampen any future equity market falls and provide an overall smoother investment journey.

¹Source: CFA Stocks Bonds and Bills Data. US equities represented by large cap US equities and government bonds represented by US government 20-year bonds and cash represented by 30-day T-bills. All returns are total returns in USD. Scenario returns based on Monte Carlo method using historic data based on a normal distribution.