What is a Drawdown?
A drawdown is a peak-to-trough decline during a specific period for an investment, trading account, or fund. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. If a trading account has $10,000 in it, and the funds drop to $9,000 before moving back above $10,000, then the trading account witnessed a 10% drawdown.
Drawdowns are important for measuring the historical risk of different investments, comparing fund performance, or monitoring personal trading performance.
Why Drawdown Matters – Money
The risk factor of drawdown is essential for investors to consider, but, unfortunately, it is often overlooked.
Why is drawdown so important? To answer that question, let’s look at a couple of example investor situations and how a drawdown may affect them.
quite profitable overall, with average annual returns on investment of more than 20%. It sounds great, right? However, after looking at the past track record of using the strategy, you see that the strategy has experienced drawdowns in the amounts of $6,000, $7,000, and on one occasion, even $10,000. Nonetheless, the strategy has been profitable overall, taking a hypothetical starting investment of $5,000 to over $25,000 in a period of four years.
The drawdowns are still critical to consider for the following reason: Assume that you begin trading using the strategy, with a starting investment of $5,000, and happen to be unfortunate enough to begin trading the strategy at a time when it begins to experience one of its drawdown periods. If the drawdown matches just the lowest previous drawdown amount of $6,000, then your initial investment of $5,000 will be totally wiped out before you can enjoy the benefits of the strategy’s overall success.
Drawdowns present a significant risk to investors when considering the uptick in share price needed to overcome a drawdown. For example, it may not seem like much if a stock loses 1%, as it only needs an increase of 1.01% to recover to its previous peak. However, a drawdown of 20% requires a 25% return to reach the old peak.
A 50% drawdown, seen during the 2008 to 2009 Great Recession, requires a whopping 100% increase to recover the former peak.
Some investors choose to avoid drawdowns of greater than 20% before cutting their losses and turning the position into cash instead.
Typically, drawdown risk is mitigated by having a well-diversified portfolio and knowing the length of the recovery window. If a person is early in their career or has more than 10 years until retirement, the drawdown limit of 20% that most financial advisors advocate should be sufficient to shelter the portfolio for a recovery.
However, retirees need to be especially careful about drawdown risks in their portfolios, since they may not have a lot of years for the portfolio to recover before they start withdrawing funds.
Diversifying a portfolio across stocks, bonds, precious metals, commodities, and cash instruments can offer some protection against a drawdown, as market conditions affect different asset classes in different ways.
Stock price drawdowns or market drawdowns should not be confused with a retirement drawdown, which refers to how retirees withdraw funds from their pension or retirement accounts.
Example of a Drawdown
Assume a trader decides to buy Apple stock at $100. The price rises to $110 (peak) but then swiftly falls to $80 (trough) and then climbs back above $110.
Drawdowns measure peak to trough. The peak price for the stock was $110, and the trough was $80. The Drawdown is $30 / $110 = 27.3%.
This shows that a drawdown isn’t necessarily the same as a loss. The stock’s drawdown was 27.3%, yet the trader would be showing an unrealized loss of 20% when the stock was at $80. This is because most traders view losses in terms of their purchase price ($100 in this case), and not the peak price the investment reached after entry.
Continuing with the example, the price then rallies to $120 (peak) and then falls back to $105 before rallying to $125. The new peak is now $120 and the newest trough is $105. This is a $15 drawdown, or $15 / $120 = 12.5%.
Potential drawdown is an important factor for investors to consider, either in relation to an individual investment or their total investment portfolio. The two examples above illustrate why both the amount and duration of drawdowns are key elements to take into account.
Investors can minimize the investment risk posed by potential drawdowns by utilizing asset allocation management in their investment portfolio. For example, drawdowns in equity investments can be partially offset by investments such as bonds that offer a guaranteed, ongoing positive return on investment.