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.
- A drawdown refers to how much an investment or trading account is down from the peak before it recovers back to the peak.
- Drawdowns are typically quoted as a percentage, but dollar terms may also be used if applicable for a specific trader.
- Drawdowns are a measure of downside volatility.
- The time it takes to recover a drawdown should also be considered when assessing drawdowns.
- A drawdown and loss aren't necessarily the same thing. Most traders view a drawdown as a peak-to-trough metric, while losses typically refer to the purchase price relative to the current or exit price.
The Drawdown Explained
A drawdown remains in effect as long as the price remains below the peak. In the example above, we don't know the drawdown is only 10% until the account moves back above $10,000. Once the account moves back above $10,000, then the drawdown is recorded.
This method of recording drawdowns is useful because a trough can't be measured until a new peak occurs. As long as the price or value remains below the old peak, a lower trough could occur, which would increase the drawdown amount.
Drawdowns help determine an investment's financial risk. The Sterling ratios use drawdowns to compare a security's possible reward to its risk.
A drawdown is the negative half of the standard deviation in relation to a stock’s price. A drawdown from a share price’s high to its low is considered its drawdown amount. If a stock drops from $100 to $50 and then rallies back to $100.01 or above, then the drawdown was $50 or 50% from the peak.
A stock’s total volatility is measured by its standard deviation, yet many investors, especially retirees who are withdrawing funds from pensions and retirement accounts, are mostly concerned about drawdowns. Volatile markets and large drawdowns can be problematic for retirees. Many look at the drawdown of their investments, from stocks to mutual funds, and consider their maximum drawdown (MDD) so they can potentially avoid those investments with the biggest historical drawdowns.
Drawdowns are of particular concern to those in retirement. In many cases, a drastic drawdown, coupled with continued withdrawals in retirement can deplete retirement funds considerably.
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.
The uptick in share price needed to overcome a particularly large drawdown can become significant enough that some investors end up just getting out of the position altogether and putting the money into cash holdings 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 her 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.
Time to Recover a Drawdown
While the extent of drawdowns is a factor in determining risk, so is the time it takes to recover a drawdown. Not all investments act alike. Some recover quicker than others. A 10% drawdown in one hedge fund or trader's account may take years to recover that loss.
On the other hand, another hedge fund or trader may recover losses very quickly, pushing the account to peak value in a short period of time. Therefore, drawdowns should also be considered in the context of how long it has typically taken the investment or fund to recover the loss.
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%.