When the Market Drops: A Playbook for Drawdowns
If the previous piece in this series addressed the operating discipline that keeps a portfolio from drifting in good markets, this one addresses the operating discipline that keeps it from breaking in bad ones. Drawdowns are not a market event in any useful sense. They are a behavioral test. The portfolio that comes through a difficult period in good shape is rarely the portfolio with the most sophisticated tactical response. It is, almost always, the portfolio whose owner had written down their response before the drawdown happened, and was disciplined enough to actually execute it.
This piece is the playbook. Not for predicting drawdowns, no one can, but for behaving well when one occurs, which over a long enough horizon is the more consequential capability.
The honest framing of a drawdown.
A meaningful drawdown, meaning a peak-to-trough decline of twenty to forty percent in the broad market, occurs, on average, every several years. The timing is unforecastable. The fact of recurrence is not. An investor with a thirty-year horizon should expect to live through five or six of them; an investor with a twenty-year horizon, perhaps four. Each will arrive with its own narrative, a banking crisis, a pandemic, a sovereign debt fear, a technology unwind, and each narrative will feel, in the moment, like the one that breaks the long-arc case for staying invested.
That feeling is not a signal. It is the drawdown doing what drawdowns do.
The operators most at risk during these periods are not the ones who knew the drawdown was coming and prepared for it. They are the ones who, in calm markets, agreed to a portfolio structure that would let them sleep through difficult quarters, and then, in the drawdown, discovered that their actual risk tolerance was different from the one they thought they had. This is a near-universal experience. It is also addressable, if the work is done before rather than during.
Behavior #1: Do almost nothing.
The single most useful behavior during a drawdown is the one operators are wired to find the hardest. The instinct to do something, to "manage the situation," to "take risk off the table," to "wait until things stabilize", is the same instinct that built the business in the first place. It is well-suited to running an operating company. It is poorly suited to managing a portfolio through a drawdown.
The reason is straightforward. The "manage the situation" instinct expresses itself, almost invariably, as selling. Selling during a drawdown crystallizes the loss into a permanent reduction in capital. Worse, it usually happens close enough to the bottom that the recovery, which, historically in diversified portfolios, has tended to follow within a few quarters, happens with the capital sitting on the sidelines. The behavioral cost compounds across cycles. An investor who has sold during three meaningful drawdowns over a thirty-year period has, in the typical case, given up a material portion of their long-arc compounding to behavior, not to markets.
"Do almost nothing" is not a passive posture. It is an active commitment, made in advance, to a specific set of behaviors that look like inactivity but are not.
Behavior #2: Execute the pre-stated rebalancing rule.
The portfolio's Investment Policy Statement should specify, in advance, the rule for rebalancing in response to material market movements. The rule is mechanical: when the equity allocation has fallen below its target band by more than the agreed tolerance, the portfolio rebalances back toward target by selling assets in the over-weighted layers (typically fixed income or cash) and buying in the under-weighted layer (equities). The rule says nothing about market views, sentiment, or what is on the front page of the financial press. It says: rebalance.
This is contrarian by construction. During a meaningful drawdown, the rebalancing rule will direct the portfolio to buy more of the assets that have just fallen, which is, in the moment, the precise behavior every emotional signal is telling you to avoid. The rule is what overrides the signal. The rule is the reason it gets executed.
Two notes. First: the rule must be agreed in writing before the drawdown. A rebalancing rule invented during a drawdown is an emotional decision dressed in mechanical language. It will not be executed. Second: the rule should specify the threshold and the action with enough precision that an adviser can execute it without re-litigating the policy. "Rebalance when the equity weight falls more than five percent below target" is a rule. "Rebalance opportunistically when the time feels right" is not a rule; it is a non-decision wearing a rule's clothing.
Behavior #3: Tax-loss harvesting, executed deliberately.
Drawdowns are uncomfortable. They are also, in taxable accounts, one of the few times the household can capture a meaningful and durable tax benefit. Tax-loss harvesting, selling positions held at a loss to realize the loss for tax purposes, then replacing them with similar but not substantially-identical exposure to preserve the portfolio's market posture, converts the unpleasantness of a drawdown into a real reduction in the household's effective tax liability over time.
The specific mechanics are intricate enough that they belong with the household's CPA, not in this article: wash-sale rules, holding periods, the difference between short-term and long-term losses, the interaction with concentrated positions, the placement decisions across taxable and tax-advantaged accounts. What matters for our purposes is that the harvesting opportunity exists during drawdowns and not after, and that capturing it requires the portfolio manager and the CPA to be coordinating in real time, not at year-end.
A drawdown is an opportunity for the adviser, CPA, and household to coordinate on tax-loss harvesting in real time. Waiting until the next quarterly review can mean missing the harvesting window for that drawdown.
Behavior #4: The behavioral check-in.
A drawdown is the moment the adviser–client relationship either earns its keep or reveals that it never had any. The behavioral check-in, a deliberate conversation between the portfolio manager and the household during meaningful drawdowns, is the work that distinguishes a portfolio-construction practice from a transaction service.
What the conversation covers, in practice, is whether anything in the household's situation has materially changed in a way that warrants reconsidering the IPS. Most of the time, the answer is no, the IPS was built for exactly this period, and the right behavior is to follow it. Occasionally, the answer is yes: a household-level change (a planned distribution moved up, an unexpected liquidity need, a meaningful shift in income) genuinely warrants a different posture. The behavioral check-in is the venue in which that judgment gets made deliberately, rather than emerging from a series of small, reactive trades.
The behavioral check-in is also the conversation that, repeated across drawdowns over years, builds the household's understanding of its own risk tolerance, not in theory, but in the dollars-on-paper sense. Each drawdown that gets handled well makes the next one easier to handle. That compounding is one of the most underrated benefits of a long-tenured portfolio relationship.
What not to do.
The list of behaviors to avoid during a drawdown is short, repetitive across cycles, and important.
- Do not abandon the IPS because the IPS feels stale. The IPS feels stale during every drawdown. That is its design feature, not a defect.
- Do not increase the frequency of portfolio review. Daily checking does not improve outcomes; it raises the probability of behavioral error.
- Do not consume more financial media during drawdowns than you consume in calm markets. The signal-to-noise ratio is materially worse, and the content is calibrated to engagement, not to your situation.
- Do not seek a new adviser during the drawdown. New advisers acquired during difficult markets begin the relationship at the worst possible moment for understanding the household. The right time to evaluate the relationship is in calm markets.
- Do not concentrate further into recent winners on the theory that they will hold up. The portfolio's diversification exists precisely to absorb the difference between confident-prediction and what actually happens. Defeating it in the middle of a drawdown is the opposite of risk management.
The principle.
A drawdown is not a market event the portfolio manages. It is a behavioral test the household manages. The portfolio that comes through in good shape is one whose owner, in calm markets, agreed to a structure that would survive difficult quarters, and was then disciplined enough, when the difficult quarters arrived, to actually follow it. Most of that discipline is in the written work done before the drawdown began. The mechanics during the drawdown are mechanical. The behavior is what is hard, and the behavior is what is decisive.
The next piece widens the lens beyond the portfolio itself to the team of professionals around the portfolio, and the coordination discipline that determines whether each piece of the household's financial picture is actually working with the others.
Alphyn Capital Management, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. This post is for informational and educational purposes only and does not constitute personalized investment, tax, or legal advice or a recommendation to buy or sell any security. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal. No portion of this article is to be interpreted as a testimonial or endorsement of the firm's investment advisory services. Please consult qualified professionals before making any investment decisions. This post may contain forward-looking statements and represents the author's opinions as of the date of publication. Such statements are inherently uncertain, and actual outcomes may differ materially. ACML does not undertake to update any forward-looking statement.