Drawdown: What It Is, Risks, and Examples

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 measures the historical risk of different investments, compares fund performance, or monitors personal trading performance. It 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.

Understanding Drawdowns

As noted above, a drawdown measures an investment or trading account's decline from the peak before it recovers back to that peak. The Ulcer Index (UI) helps to track these movements. It remains in effect as long as the price remains below the peak. In the example above, 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 can refer to the negative half of the distribution of returns of a stock’s price; i.e., the change from a share price’s peak to its trough is often considered its drawdown amount. For example, 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.

Stock Drawdowns

A stock’s total volatility is typically measured by its standard deviation, yet many investors, are mostly concerned about drawdowns instead. This is especially true for retirees who withdraw funds from pensions and retirement accounts

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.

Risk of Drawdowns

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. But 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.

Assessment of Drawdowns

Drawdown risk is typically mitigated by having a well-diversified portfolio and knowing the length of the recovery window. If a person is early in their 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.

But 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.

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 its 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 (AAPL) stock at $100. The price rises to $110 (peak) but then swiftly falls to $80 (trough) and then climbs back above $110. The peak price for the stock was $110, and the trough was $80. Keeping in mind that drawdowns measure peak to trough, we can determine that the drawdown is 27.3% or $30 ÷ $110 x 100.

This shows that a drawdown isn't necessarily the same as a loss. The stock's drawdown was 27.3%, yet the trader would show 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.

Now let's suppose 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 drawdown of 12.5% OR OF $15. This is calculated as $15 ÷ $120.

The Bottom Line

There's a fine line between turning a profit and losing your money when you invest your money. But understanding some of the intricacies of the investment world may help you keep your head in the game. Knowing what drawdowns mean and how they can help assess risk and compare investments may help you become a better trader as you mitigate your losses.