What is a Drawdown
A drawdown is the peak-to-trough decline during a specific recorded period of an investment, fund or commodity security. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Those tracking the entity measure from the time a retrenchment begins to when it reaches a new high.
BREAKING DOWN Drawdown
This drawdown method of recording is useful because a valley can't be measured until a new high occurs. Once the investment, fund or commodity reaches a new high, the tracker records the percentage change from the old high to the smallest trough. Drawdowns help determine an investment's financial risk. Both the Calmar and Sterling ratios use this metric to compare a security's possible reward to its risk.
Drawdown is simply the negative half of standard deviation in relation to a stock’s share price. A drawdown from a share price’s high to its low is considered its drawdown amount.
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 concerned about drawdowns. During volatile markets, and markets that have a possibility of a correction, drawdown is a serious concern for retirees. Many are starting to look at the drawdown of their investments, from stocks to mutual funds, and considering their possible maximum drawdown (MDD) potential.
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 previously held position. However, a drawdown of 20% requires a 25% return, while a 50% drawdown – seen during the 2008 to 2009 Great Recession – requires a whopping 100% increase to recover the same position. Most investors want to avoid drawdowns of 20% or greater before cutting their losses and turning a position into cash investments.
Retirees, in particular, feel this risk, if they are doubling down on the drawdown economics as they withdraw further funds from the principal of their investments to fund their retirements. In many cases, a drastic drawdown, coupled with continued withdrawals in retirement can shorten retirement funds considerably.
Typically, drawdown risks are mitigated by having a well-diversified portfolio and knowing the length of the recovery window. If a person is early in his career or has more than 10 years until retirement, the drawdown limit of 20% that most financial advisors expound should be sufficient to shelter portfolios for a recovery. However, retirees need to be especially careful about drawdown risks in their portfolios. Diversifying a portfolio across stocks, bonds and cash instruments can offer some protection against a drawdown, as market conditions affect different classes of investments in different ways.
Stock price or market drawdown should not be confused with retirement drawdown, which refers to how retirees should withdraw funds from their pension or retirement accounts.