What Is a Drawdown?
Let me explain what a drawdown is in investing. It's the loss you experience from the highest point of your investment to its lowest point, usually expressed as a percentage difference between that peak and the following trough. You can use it to gauge an investment's historical risk, compare different funds, or keep an eye on your portfolio's performance.
Here's how you'd calculate it: suppose your investment account starts at $20,000, drops to $18,000, and then bounces back to $20,000. That means you had a 10% drawdown during that period. You figure it out by subtracting $18,000 from $20,000 to get $2,000, then dividing that by $20,000, which gives you 0.10 or 10%.
Key Takeaways on Drawdowns
Drawdowns are all about measuring downside volatility and assessing the historical risk tied to a specific investment. Remember, it's not just the size of the drop that matters; you also need to think about how long it takes for the investment to recover its value. And don't confuse a drawdown with a straight loss—that's the difference between what you paid for an asset and its current or selling price.
The Basics of Drawdowns in Investing
Peaks and troughs are the high and low points in a price cycle, and you can track these using something like the Ulcer Index, a technical indicator that measures downside risk. This index only captures the trough's size after the investment has recovered to its original peak. If you measure it too early, the drawdown could end up being larger if the value drops further. In my earlier example, you'd record the drawdown only after the account gets back to $20,000.
Tracking drawdowns helps you assess the volatility or risk of a fund, asset, or other investment. While standard deviation often measures a stock's volatility, some ratios like the Sterling ratio use drawdowns to weigh risk against potential rewards. This metric might be especially useful if you're planning to withdraw funds soon, like if you're retired.
Risk of Drawdowns
The main risk with drawdowns is the percentage increase needed to recover from them. If a fund typically sees drawdowns of 1% or less, it only needs about a 1.01% rise to get back to its peak. But for a 20% drawdown, you'd need a much bigger recovery in share price to break even.
If that required uptick is too large, you might decide to sell off and take the cash instead of waiting. However, if you don't need the money right away, you're often better off holding on. Look at the 2008 financial crash: the market's five worst days had drops between 6.1% and 9.0%. Many people pulled out, but those who stayed saw returns of 69.9% to 147.5% over the next five years. Exiting means you miss out on any recovery.
Risk for Retirees
Drawdowns hit harder if you have a short time frame, like retirees do, because you might not have years to wait for recovery. You should figure out the maximum drawdown you're okay with and compare it to a stock or fund's history before investing. A financial advisor can help with that.
To limit this risk, build a diversified portfolio with stocks, bonds, commodities, cash, and other assets. Since these don't all move the same way, not everything will drop at once, giving you more time to recover without losing your whole income stream.
Just to clarify, a stock or market drawdown isn't the same as a retirement drawdown, which is about withdrawing funds from your retirement account or pension.
Example of a Drawdown
Let's say you buy stock in XYZ Corp. at $100 per share. It climbs to $110, then falls to $80. If it doesn't go lower before recovering to $110, the drawdown is $110 minus $80, which is $30, divided by $110, equaling about 27.3%.
This shows drawdowns aren't the same as losses. Your unrealized loss at $80 would be $20 from your purchase price, not from the peak. If the stock then hits $120, drops to $105, and recovers, that's a new drawdown of $15 or 12.5%.
The Bottom Line
A drawdown is simply the decline from an asset or fund's peak to its trough over a period, measuring historical volatility to guide your investment choices based on risk tolerance. If you have a long time horizon, higher volatility might be fine since you'll have time to recover. For shorter timelines, like retirement, stick to lower-volatility options. Diversification always helps reduce drawdown risks.
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