What Is a Drawdown?

A drawdown is typically quoted as the percentage difference between the peak of an investment and its following trough. It can be used to measure an investment's historical r𓃲isk, compare the performance of 🌼different funds, or monitor a portfolio's performance.

The drawdown would be calculated like this if an investment account of $20,000 dropped down to a value of $18,000 and then recovered to $20,000. The account eꦍxperienced a 10% drawdown in this period:

$20,000 - $18,000 = $2,000 ÷ $20,000 = 0.10 (or 10%)

The Basics of Drawdowns in Investing

Peaks and troughs represent the highest and lowest points in a price cycle. These movements can be tracked using the 澳洲幸运5开奖号码历史查询:Ulcer Index (UI), which is a technical indicator that measures downside ris🦹k.

The index can only measure the size of a trough after the fund has recovered to its original peak. If the drawdown is recorded before, the fund may experience an even larger trough, increasing the drawdown amount. In the above example, the drawdown would be recorded after the fund recovers to its original $20,000 value.

Tracking drawdowns can be used to assess the volatility or risk associated with a particular fund, asset, or other investment. A stock's volatility is often measured using 澳洲幸运5开奖号码历史查询:standard deviation, but some ratios, such as 澳洲幸运5开奖号码历史查询:Sterling ratios, use drawdowns to compare ri🌳sk to possible reward. Drawdowns may also be a more relevant metric for investors hoping to withd𝓀raw funds in a short-term timeframe, such as retirees.

The size of a drawdown is oꦅnly one part of the measurement. Equally important is the time it takes to recover from a drawdown. This will depend on the overall market conditions and t🍃he performance of a specific investment. Historically, some funds or assets recover more quickly than others.

Risk of Drawdowns

The primary risk associated with drawdowns is the uptick in share price nee🍨ded to overcome that drawdown. If a fund's historical performance shows drawdowns of 1% or less, the price would only need to increase by at most 1.01% to recover to its peak. However, a fund that experiences a drawdown of 20% must recover significantly more of its share price t🧔o reach its peak again.

If the uptick in a share price needed to recover from a drawdown is large enough, investors might decide to 澳洲幸运5开奖号码历史查询:exit the position completely and convert the🐽 remaining value of their investment to cash rather than wait out the recovery.

However, investors who don't need that money immediately are often better served by waiting for the recovery after a significant drawdown. The five worst days the stock market experienced during the 澳洲幸运5开奖号码历史查询:2008 financial crash included one-day falls between 6.1% and 9.0%. Many investors chose to exit the market after such significant losses. But from those five days, market returns were between 69.9% and 147.5% after five years.

Investo🍎rs who kept their money in the market saw their assets recover significantly over time, while those who exited completely had no cha♛nce of recovering.

Risk for Retirees

Market volatility and significant drawdowns are more problematic for investors with a short-term timeframe, such as retirees. These investors don't have as long to wait for their assets to recover their value. Retirees may need to determine the 澳洲幸运5开奖号码历史查询:maximum drawdown (MDD) they are comfortable with and then compare that to aಌ stock or fund's historical performance before decidingꦕ to invest. A financial advisor can assist with this decision.

Drawdown risk can also be limited by having a well-diversified portfolio that includes stocks, bonds, commodities, cash, and other valuable assets. Because these 澳洲幸运5开奖号码历史查询:asset classes behave differently, this kind of diversification will limit the number ♚of assets that experience simultaneous drawdowns and allow for a longer recovery time without 𓆉compromising retirees' entire income.

Example of a Drawdown

As an example, say that a trader buys stock in XYZ Corp. at $100 per share. The price rises to a peak of $110, then falls to a trough of $80. If the price doesn't drop any lower before it recovers to $110, then the peak price was $110 and the trough was $80. This means that the drawdown was:

$110 - $80 = $30 ÷ $110 = 0.273 (or 27.3%)

This also demonstrates that a drawdown isn't always the same as a loss. The XYZ stock experienced a drawdown of 27.3%, but the trader's unrealized loss at the $80 trough was $20 because they had purchased the stock at $100 per sha♔re, rather than the peaಌk price of $110.

If the price of XYZ stock then rises to a new peak of $120, drops to a new trough of $105, and then recovers to $120, that would be 🔯a new d🦩rawdown of $15 or 12.5%.

The Bottom Line

A drawdown is the peak-to-trough decline of an asset or fund's price over a certain timeframe. It measures an asset's 澳洲幸运5开奖号码历史查询:historical volatility, which investors can use to inform their investment decisions ⭕based on their level of risk toleranc🌜e.

Investors with a longer investment time frame may be more comfortable investing in assets with higher volatility since their portfolios will have longer to recover. For investors with shorter timelines, such as retirees, assets and funds with lower historical volatility are often safer investments. A well-diversified portfolio cꦕan help mitigate the risk associated with drawdowns.