A drawdown is the decline in value from a peak to a trough during a specific period for an investment, trading account, or fund. It captures the historical risk of various investments, compares fund performance, or measures personal trading performance. A drawdown is usually quoted as a percentage between the peak and the subsequent trough. For example, if a trading account starts with $10,000 and drops to $9,000 before rising above $10,000 again, it experienced a 10% drawdown.
Key Takeaways
- A drawdown shows how much an investment or trading account has dropped from its peak before recovering back to that peak.
- Drawdowns are generally quoted as a percentage, but financial figures may also be used if applicable for a specific trader.
- They provide a measure of downside volatility.
- The time needed to recover from a drawdown is an important aspect to consider.
- A drawdown is not necessarily the same as a loss. Traders usually consider a drawdown as a peak-to-trough metric, whereas losses often refer to the purchase price compared to the current or exit price.
Deep Dive Into Drawdowns
As explained earlier, drawdowns measure an investment or trading account’s fall from the peak before recovering back to that peak. This remains significant as long as the price stays below the peak. In the previous example, the drawdown is only 10% until the account value exceeds $10,000. Once surpassed, the drawdown is recorded.
Recording drawdowns is crucial because a trough isn’t measurable until a new peak forms. As long as the value stays below the old peak, a new, lower trough can increase the drawdown amount.
Drawdowns are essential for identifying an investment’s financial risk. Tools such as Sterling ratios compare a security’s potential return against its risk using drawdowns.
For example, if a stock falls from $100 to $50 before rallying to $100.01 or higher, the drawdown was $50 or 50% from the peak. Drawdowns hit retirees particularly hard—continued withdrawals and a drastic drawdown may significantly deplete retirement funds.
Stock Drawdowns Explained
A stock’s total volatility is often determined by its standard deviation, but many investors focus more on drawdowns. This is especially true for retirees who rely on income from pensions and retirement accounts.
Volatile markets and sizeable drawdowns pose challenges for retirees. By analyzing drawdown data, such as the Maximum Drawdown (MDD), investors can steer clear of investments with significant historical drawdowns.
Risk Factors Associated with Drawdowns
Drawdowns represent a significant risk for investors, particularly when considering the required increase in the stock price to offset a drawdown.
For instance, a 1% loss only needs a 1.01% gain to recover, but a 20% drawdown requires a 25% increase to return to its previous peak. During the 2008-2009 Great Recession, a 50% drawdown necessitated a staggering 100% recovery to regain prior levels.
Given these dynamics, some investors exit positions experiencing a drawdown of more than 20% to retain capital in cash holdings.
Managing Drawdown Risks
Drawdown risk is generally mitigated through a well-diversified portfolio and an understanding of the recovery window’s duration. For individuals with a long investment horizon, a 20% drawdown limit suggested by many financial advisors might suffice for eventual recovery.
Conversely, retirees must closely manage drawdowns to preserve their portfolios’ ability to meet withdrawal needs. Diversifying across various asset classes such as stocks, bonds, precious metals, and cash can shield portfolios from drawdowns, as these classes react differently to market conditions.
Note that stock price or market drawdowns differ from retirement drawdowns, which involve the strategic withdrawal of retirement funds to sustain a desired lifestyle.
Time to Recover a Drawdown Matters
Beyond the extent of drawdowns, the time needed for recovery also indicates risk. Not all investments recover the same way; some bounce back faster than others. A 10% drawdown in one hedge fund could take years to recover, whereas another might swiftly regain losses and exceed peak values.
Real-World Example of a Drawdown
Consider a trader buying Apple (AAPL) stock at $100. If it rises to $110 (peak) but then drops to $80 (trough) before rallying back above $110, the drawdown is 27.3% calculated as $30 (fall) divided by $110 (peak), or $30 ÷ $110 x 100.
This demonstrates that drawdowns are not synonymous with losses. Even if the drawdown was 27.3%, a trader might see an unrealized loss of 20% when the stock was at $80.
If the stock then rallies to $120 and dips to $105 before bouncing to $125, the new peak is $120, and the trough is $105, resulting in a 12.5% or $15 drawdown, calculated as $15 ÷ $120 x 100.
Glossary of Related Terms
- Is a Retirement Drawdown Same as a Stock Drawdown?: No. A stock drawdown is the decline from peak to trough, whereas a retirement drawdown involves withdrawing a portion of retirement savings to sustain a standard of living.
- What Is a Loan Drawdown?: The term refers to disbursing funds from a lender to a borrower, like a mortgage.
Final Thoughts
Understanding drawdowns helps differentiate between risk levels in various investments and assesses potential returns. Mastery of these financial nuances allows investors to stay grounded and mitigate losses to become more proficient traders.
Related Terms: Ulcer Index, Sterling Ratios, Standard Deviation, Maximum Drawdown, Dow Jones, Volatility.
References
- Fidelity. “Drawdown”.
