Drawdown 

In technical analysis and finance, a drawdown refers to the decline in the value of an investment, portfolio, or trading account from its peak value to its lowest point before recovering. It is a measure of the maximum loss an investor or trader experiences during a specific period, typically expressed as a percentage. Drawdowns are used to assess the risk and volatility of an investment. They provide insights into the potential losses an investor might face when holding a position, and they are an important metric for evaluating the performance of trading strategies or investment portfolios. 

While investing, managing risks are of equal importance to generating returns. One such key metric is drawdown, which helps investors understand just the kind of risk an investor is taking concerning their portfolio. It gives you an idea of the amount your investment might decline from its peak. It, therefore, provides a higher level of insight into prospective losses. Drawing down is a critical component in risk management, and it’s essential, especially for serious investors. In this blog, I try to go in-depth into what drawdown is, how it works, what the types are, and why it is so crucial in risk management. 

What Is Drawdown? 

Drawdown refers to the decrease in an investment’s value from its peak to trough over a given period. As such, it is one way of looking at downside risk and will help investors estimate the amount they may lose on security in a specific period. Drawdown is usually expressed as a percent and is thus important for both the short—and long-term investor. 

For example, for an investor whose portfolio peaks at US$50,000 and then falls to US$45,000, the drawdown is 10%. The important point in understanding drawdown is that the investor can then mark how much his or her investment has gone down and, more importantly, the amount it needs to recover to break even. 

Understanding Drawdown  

Drawdown is an important concept in risk management and investment strategy. It points out the possible loss during unfavourable market conditions. Unlike loss, which refers to the real decline in the value of an investment, drawdown concerns temporary declines from the highest value reached by an investment. 

It helps the investor draw down to realise how volatile their investments are. The higher the drawdown, the more the investment risks and the higher the variation in value; conversely, a small drawdown is an indication that the investment is relatively stable and not so risky. 

It is worth noting, however, that a drawdown does not occur until the investment is sold. If the market bounces back, an investment might regain its losses and even reach a higher level than the former peak. 

Types of Drawdowns 

There are many types of drawdowns that an investor should know about, each in its own way important for the evaluation of risk. These include: 

1. Maximum Drawdown

This is the most frequent type of drawdown. Maximum drawdown measures the deepest trough from peak to trough over a given period. It helps investors understand the worst-case scenario associated with their investment and, therefore, essentially informs them about how much value can be lost during a market downturn. 

2. Relative Drawdown

Unlike the maximum drawdown, the relative drawdown focuses on a concern with the percentage decline from the initial value of the investment. This is particularly useful when comparing different investments and determining which has a higher risk than others. 

3. Average Drawdown

The average drawdown calculates the average of all drawdowns over a certain time. It smooths the individual drawdowns by providing the overall risk of the investment. 

4. Calmar Ratio

Though not a direct form of drawdown, the Calmar Ratio is a method of showing the relationship between risk and return, using the maximum drawdown in contrast to an investment’s annual return. The higher the Calmar Ratio, the better the risk-adjusted return; thus, it is a tool worthwhile for investors who balance return with risk. 

Calculations of Drawdown 

Calculation of drawdown is easy yet important in understanding the risk profile of any investment. The formula for calculating the drawdown is as follows: 

Drawdown = (Peak Value – Trough Value/ Peak Value)* 100 

Let’s take an example: Assume that an investor’s portfolio peaks at US$ 100,000 and then declines to US$ 80,000; the calculation of drawdown will be: 

(100,000 – 80,000/ 100,000) * 100 = 20% 

That means the investment had a 20% drawdown over that period. Investors often monitor these percentages to determine the magnitude of a decline that they could tolerate before having to rebalance their portfolio. 

Examples of Drawdown 

1: US Stock Market Correction 

Let’s look at an example in the US stock market. During the 2008 financial crisis, more than 50% drawdowns were seen rather frequently. Suppose, for example, that a portfolio reaches its peak at US$200,000 and then goes down to US$100,000. It would have incurred a 50% drawdown. Investors who had never expected such staggering plunges made huge losses, while the ones who had diversified their portfolios were able to keep their drawdowns in check. 

2: Drawdown in a Balanced Portfolio 

Assume that, in Singapore, an investor has a balanced portfolio of equities and bonds in reasonable proportion. In the event of a market contraction, for instance, the portfolio could have a peak of US$50,000 and a drawdown to US$45,000, translating to a 10% decline. Given that bonds within the portfolio would generally be stable, the drawdown could be smaller. 

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