One of the hardest aspects of being a long-term investor is that

even the best investments, or investment portfolios, suffer large

drawdowns.

Charlie Munger

has a take on drawdowns worth quoting in detail:

“I think it's in the nature of long-term shareholding with the normal

vicissitudes in worldly outcomes and in markets that the long-term

holder has his quoted value of his stock go down by say 50

percent. In fact, you can argue that if you’re not willing to react

with equanimity to a market price decline of 50 percent 2 or 3 times

a century, you’re not fit to be a common shareholder and you

deserve the mediocre result you are going to get—compared to

the people who do have the temperament who can be more

philosophical about these market fluctuations.”1

Munger not only argues that you have to be calm about these

declines, he goes further to suggest that if you cannot deal with

them “you deserve the mediocre result you are going to get.” In

other words, big drawdowns are a price to pay for superior long-

term investment returns.

The partnership that Munger managed produced a compound

annual growth rate of 19.8 percent from 1962 to 1975, but it

suffered a 53.4 percent drawdown in the 2 years ended in 1974.2

Long-term wealth creation for companies is also heavily skewed.

Hendrik Bessembinder, a professor of finance at Arizona State

University, studied the roughly 28,600 public companies that have

been listed in the U.S. from 1926 to 2024. Key to his definition of

wealth creation is that a stock produce returns in excess of one-

month Treasury bills.

Over the last two weeks, I’ve been in a bit of a drawdown in my day trading,

meaning that I’ve been losing money and taking away from previous

gains. I dug myself a hole, and now I’m working on recovery. I have gone

through this more times than I could count, but I don’t know that it

gets easier. It is just never fun to be in a drawdown. It’s frustrating,

it’s disappointing, and it’s confusing. Nothing about it is good, but

it is an inevitable part of being an investor.

Types of Drawdowns

Not all drawdowns are the same. I would say

having one or two large red days that give back a week or so of progress

constitutes a drawdown. Having one or two red months that give back

months of progress also constitutes a drawdown but is certainly more

concerning and more substantial. On the other hand, drawdowns that

extend for years are not a drawdown but are just an indication that your

strategy is not working, as you can imagine. Over the years, I have

known traders who have experienced each of these types of drawdown

scenarios.

In the first scenario, which is the least severe, we’re talking about

a drawdown where you’re giving back perhaps a week or two of profit.

This is the type of drawdown that I experience the most frequently. It

happens several times a year that I dig myself a little bit of a hole,

and it takes a few weeks to recover. In my latest example that I’m

currently recovering from, I put together five consecutive red days.

It’s the second time I’ve done that this year. It’s certainly not fun.

My Latest Drawdown

It began with a red day on a Thursday, where I lost about $500. It

felt negligible, and I wouldn’t even consider that a drawdown. That’s

just a small red day. Then, on Friday, I proceeded to lose about $5000,

and I was 100% giving in to FOMO.

There was a stock that had made a really big move on Thursday. I had

missed it because the bulk of the move was later in the day, and I came

in bright and early on Friday morning. I jumped in with a 5 or 6000

share position. I thought I would catch a quick continuation trade, and

instead, I lost $5800 in just a few minutes of trading and I hit my max

loss. It was not a great way to go into the weekend. It was two red days

in a row, but not a significant drawdown either. It was just a little

disappointing.

Then, on Monday morning, I sat back down and had a third red day in a

row. It was not quite $5000, but it was a substantial red day. Come

Tuesday morning, I lost $4500 and had another red day. I tried to

exercise composure and hold it together, but I wasn’t able to do it. On

Wednesday, I finished green before commissions, but only by about $30. I

was red about $300 on the day after fees and commissions. On Thursday,

we had a market holiday for Thanksgiving, and on Friday, I bounced back

with a $5000 green day. I made another $5000 on Monday, and today, I was

up $2000. At this point, I’ve recovered about 80% of what I lost in my

drawdown. I’m ready to be a bit more aggressive going into the rest of

the week, as I’m feeling more confident.

Reducing Share Size

After my fourth red day in a row, I decided to reduce my share size

so I could only trade with a max of 10,000 shares. I think that was a

good decision to help me stay reined in. Ultimately, that decision is

what helped prevent me from having a multiweek drawdown. Usually, once

I’ve recovered about half of my profit or half of my loss is when I

start to size up, pull back the restrictions, and be a little bit more

aggressive.  Since this drawdown only amounted to about $15,000 in

total, after I’d made back $7500, I was starting to feel like I was back

in the driver’s seat.

So now, let’s talk about what separates this drawdown from a trader

who might go on a multi-week or multi-month drawdown. I have known many

traders who have had many years of consistency but found themselves in

the midst of back-to-back red months, very poor accuracy, emotionally

fueled trading, and a substantial drawdown. These types of situations

always begin with one or two red days, just like my latest drawdown.

However, something happens here that makes it worse. Rather than enforce

guardrails and boundaries to slow down the bleeding, they will get

stubborn, frustrated, and emotionally hijacked. That leads them to trade

even more aggressively in the face of loss. This is a human response.

When something is being taken away, we reach for it, and we pull even

harder to get it back. This response, however, is not conducive to

success as a day trader.

Trade Smart, Not Hard

When gains become hard to capture, rather than trying harder, you

want to try less. This means when the market is cold, you want to ease

off the throttle and slow down, but the instinct is to double down to be

even more aggressive. That’s because now, not only are you trying to

make your daily goal, but you’re also trying to recoup what you

previously lost, which means in a poor market. You’re now trying to make

twice what you would make on average during a hot market. That’s gonna

be pretty hard to do. The more days that go by where you’re falling

short of this unrealistic goal, the more frustrated and emotionally

compromised you become. I say all this from a place of being very

empathetic to those who are in this position because I have been there

myself. I know the pain that comes with experiencing a large loss. It’s

important to note that a large loss is relative. What might be large to

me could be astronomical to you. What could be large to you could be

very small to someone else. It’s all relative. The point is that the

pain is the same.

If we gauged your response just based on how much pain you have, you

could be in as much pain from losing $100 as I might be in from losing

$10,000. That pain and discomfort is what will then lead to impulsive

trading. But, here’s the problem: if you get emotionally triggered when

you’re down $5000, imagine what’s gonna happen when you go into a

drawdown of $50,000 or $75,000. The more you lose, the deeper you fall

into a state of emotional hijack. That’s why it is so important to do

everything possible to preserve your emotional state. So, after having

one or two or three red days in a row, you have to acknowledge that what

you’re doing is not working. It doesn’t mean that your strategy doesn’t

work. It doesn’t mean that you’re no longer a profitable trader. It

just means, most likely, that there’s been a shift in the market that

you’re trading, and it’s not conducive to your strategy right now.

So, the things I do when I’m faced with 23 or four red days in a row

is I reduce my share size, and I begin doing a meditation before I start

trading. And what I’m meditating on is being okay with the discomfort

that I’m feeling at that moment, being okay with not taking any trades

today, and being okay with focusing on the best quality setups, even if

that means there’s only one or two of them this week. I will tell you

that it is a struggle. On Tuesday morning, I told myself I was going to

be calm, cool, and collected. The next thing you know, within a period

of 12 seconds, I incurred a $5000 loss. It was instantaneous. For just a

moment, I gave in to my emotional impulse to chase a stock and press

that buy button. It flushed down, and I lost over a dollar a share. I

lost my discipline in that moment. I came into the day with discipline,

and then I suddenly stopped being disciplined, and that was on me. I

should have been more disciplined.

The Dangers of Emotional Capitulation

One of the biggest dangers of falling into a multi-week and a

multi-month drawdown is when you emotionally capitulate. Emotionally

capitulating means you basically say, “screw it, I have nothing left to

lose.” At that point, you’re taking tremendous amounts of risk, and

you’re positioning yourself, unfortunately, to take catastrophic

losses.  What will ultimately happen if you continue down that path is

you will be faced with a trade that could blow up your account because

your account keeps getting smaller and smaller and smaller until it’s

finally gone. Now, once you’ve hit rock bottom, then there’s a whole

different conversation about how you got there. A multi-month drawdown

turns into an annual or a multiyear drawdown when a trader digs their

heels in and refuses to acknowledge that what they’re doing is not

working. I have watched traders make millions and millions of dollars

only to lose it because they refused to adapt to a change in the market.

It’s important to know when to walk away and when to take profit off

the table. That is true on an intra-day basis, on a weekly basis, on an

annual basis, and when it comes to your career as a trader. However,

many people, when faced with loss, begin chasing the loss. They struggle

with the sunk cost fallacy that because they already have so much

invested, they feel they are justified in chasing those losses to try to

recover.

Hitting Rock Bottom

Somebody recently asked me what my turning point was in my career. My

turning point was when I hit rock bottom. I didn’t have to lose half a

million dollars to hit rock bottom. I didn’t make 5 million and then

lose 5 million. For me, rock bottom was accumulating $30,000 of credit

card debt and spending 18 months trying to learn how to trade with

nothing to show for it. I had made about $30,000, and then I lost it. In

the meantime, I’d accumulated credit card debt by paying for my cost of

living on a credit card instead of taking money out of my account. So

every time I would lose money in my account, I was losing the ability to

continue to trade. My turning point came after a final big loss that

made it so I couldn’t trade in my account until I added more money. The

reason this was a turning point was because it forced me to look very

carefully at what I was doing that was working and what I was doing that

was causing me so much trouble. Hitting rock bottom also forced me to

come to the table with a sense of discipline that I didn’t have before. I

knew that this was going to be my final chance to make it work and that

I had to do everything the right way. I could not continue to give in

to my emotional impulses. Had I not hit rock bottom, I think I would

have likely continued to lose money if I had added more money to the

account.

Necessity is the Mother of Invention

There’s a quote that “Necessity is the mother of invention.” In my

case, I simply could not afford to make another mistake. I did a lot of

interesting things during my period of recovering from those losses. I

remember putting a tack on my shoe so I would feel uncomfortable while I

was standing and trading. It helped remind me to walk away sooner, and,

of course, I would take the tack out of my shoe once I was finished

with trading. I couldn’t afford home heating oil since I was putting

that money into my trading account, and I had to collect and split

firewood to be able to keep the house warm through the winter. I spent

my afternoons outdoors doing this type of manual labor instead of

staring at the computer gambling during the hours of the market, where I

generally lost money. Trading did not come naturally to me. I didn’t

have much beginner’s luck, and I found myself easily giving in to the

fear of missing out. So, for those who are in any of the phases of

drawdown, I think it’s important to realize that to stop spiraling, you

seriously need to stop doing what you’re doing right now in your

trading. That requires having a very high level of discipline. The

bigger the drawdown, the more discipline it requires.

You may only be able to sit in front of your computer without falling victim to FOMO

for half an hour a day, but if that’s all you can manage, then you

should just do the 30 minutes of trading and then come back and try

again tomorrow. The last thing you wanna do is continue the downward

spiral and the cycle of getting more and more aggressive to try to

compensate for losses. I know from experience that that is a path to

hitting rock bottom. It’s just not worth it. So, while being in a

drawdown is never fun, the depth of your drawdown is within your

control. No matter how deep in the red you are right now, you have a

choice to take a step back. Look at what you’re doing that’s working,

and look at what you’re doing that’s not working, and create a set of

guard rails that you will follow to keep you on the track to recovery.

In my new book, How To Day Trade: The Plain Truth,

I lay out 20 guard rails that I’ve implemented in my trading that have

helped me during periods of drawdown. I used these just this past week

to help me recover and get back on track before I dug myself a

multi-week or a multi-month drawdown. I encourage you guys to pick up a

copy of the book and take a look at these guardrails.