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 risk, compare the performance of different funds, or monitor a portfolio's performance.

The drawdown wou💮ld be ca🍰lculated 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 experienced 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官方开奖结果体彩网:Ulcer Index (UI), which is a tech🐻nical indicator that measures downside risk.

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官方开奖结果体彩网:standard deviation, but some ratios, such as 澳洲幸运5官方开奖结果体彩网:Sterling ratios, use dra♛wdowns to compare risk to possible re𓆉ward. Drawdowns may also be a more relevant metric for investors hoping to withdraw funds in a short-term timeframe, such as retirees.

The size of a drawdown is only 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 and𓃲 the 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 needed to overcome that drawdown. If a fꦐund'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 to 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官方开奖结果体彩网:exit the position comple♒tely and con🦩vert 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官方开奖结果体彩网: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.

Investors who kept their money in the market saw their assets recover significantly over time, while those who exited completely had no chance of reco🦋vering.

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官方开奖结果体彩网:maximum drawdown (MDD) they are comfortable with and then compare that to a stock or fund's historical perf🔯ormance before deciding 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官方开奖结果体彩网:asset classes behave differently, this kind ꦇof diversification will limit the number of assets that experience simultaneous drawdowns and allow for a longer recovery time without compromising 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 ไat the $80 trough was $20 because they had purchased the stock at $100 per share, rather than the peak price of $110.

If the price of XYZ stock then rises to a new peak of $120, drops to a ne🃏w trough of $105, and then recovers to $120, that would be a 🦹new drawdown 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官方开奖结果体彩网:historical volatility,🍌 which investors can use to inform their investment decisions based on their level of risk tolerance.

Investors with a longer investment time frame may be more comfortable investing in assets with higher volatility since their portfolios wi༺ll 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 can help mitigate the risk associated with drawdowns.