Understanding Drawdowns: Definition, Risks & Recovery Time

What Is a Drawdown in Finance?

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 would be calculated 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%)

Drawdowns in Investing: The Basics

Peaks and troughs represent the highest and lowest points in a price cycle. These movements can be tracked using the Ulcer Index (UI), which is a technical 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 standard deviation, but some ratios, such as Sterling ratios, use drawdowns to compare risk to possible reward. 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 and the performance of a specific investment. Historically, some funds or assets recover more quickly than others.

Drawdown Risks Explained

The primary risk associated with drawdowns is the uptick in share price needed to overcome that drawdown. If a fund's historical performance shows drawdowns of 1% or less, then 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, then investors might decide to exit the position completely and convert 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 that the stock market experienced during the 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 recovering.

Drawdown Risks for Retirees

Market volatility and significant drawdowns are more problematic for investors with a short-term time frame, 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 maximum drawdown (MDD) they are comfortable with and then compare that to a stock or fund's historical performance 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 asset classes behave differently, this kind of diversification will limit the number of assets that experience simultaneous drawdowns and allow for a longer recovery time without compromising retirees' entire income.

Practical 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 at 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 new 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 time frame. It measures an asset's 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 will 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.