What Is a Drawdown?
A drawdown is the decline in the value of an investment from a prior peak to the subsequent trough. It is normally expressed as a percentage of the peak value and is used to quantify downside risk and an investment’s historical worst losses over a given period.
Why it matters
– Shows how much an investor would have lost if they bought at a peak and held through a trough.
– Helps compare risk across funds, strategies, or assets (complements measures like standard deviation).
– Important for investors with short time horizons (e.g., retirees) because large drawdowns can be hard to wait out.
How to calculate a drawdown
– Drawdown (%) = (Peak value − Trough value) / Peak value × 100
– Required recovery gain (%) to return from the trough to the prior peak = (Peak / Trough) − 1, equivalently drawdown / (1 − drawdown) in decimal form.
Examples
– Simple account example: $20,000 → $18,000 → back to $20,000. Drawdown = (20,000 − 18,000) / 20,000 = 10%.
– Stock example: Bought at $100, price rose to $110 (peak), fell to $80 (trough). Drawdown = (110 − 80) / 110 = 27.27%. The unrealized dollar loss relative to the buy price ($100 → $80) is $20 (20%), which is different from the peak-to-trough drawdown. Required gain to recover a 27.27% drawdown is 37.5%.
Types and related metrics
– Maximum drawdown (MDD): the largest peak-to-trough decline over a specified timeframe—commonly cited to assess worst historical loss.
– Recovery time (time to regain prior peak): equally important—how long it took for the asset to climb back to the prior peak.
– Ulcer Index: measures depth and duration of drawdowns (focuses on downside stress rather than both upside/downside volatility).
– Ratios using drawdowns: e.g., Sterling ratio compares excess return to average drawdown; alternative to Sharpe ratio for downside-focused risk assessment.
Key limitations
– Historical drawdowns are not guarantees of future drawdowns.
– A drawdown can only be fully measured after the asset recovers to the prior peak; interim measurements can underestimate the final drawdown if prices drop further.
– Drawdown magnitude alone is incomplete without recovery time.
Risk implications (why drawdowns matter)
– The larger the drawdown, the larger the percentage gain required to recover. For example, a 50% drop needs a 100% gain to return to the prior peak.
– Large drawdowns can force liquidations (taxes, margin calls, behavioral panic) and are particularly harmful to those withdrawing funds (retirees).
– Studies of past crises (e.g., 2008) show dramatic short-term losses followed by substantial long-term recoveries—but only for investors who stayed invested.
Practical steps to assess and manage drawdown risk
1) Determine your drawdown tolerance
– Decide the maximum peak-to-trough loss you can tolerate emotionally and financially (e.g., 10%, 20%).
– For retirees, include sequence-of-returns risk: the risk that large early losses combined with withdrawals permanently impair a portfolio.
2) Measure historical drawdowns for candidates
– Compute MDD and average drawdown for funds or indices over relevant windows (1, 5, 10+ years).
– Look at recovery times, not just peak losses.
3) Set an asset allocation aligned to tolerance
– Higher equity allocations typically have higher historical drawdowns but greater long-term return potential.
– Add lower-volatility assets (bonds, short-term cash, TIPS) to reduce expected drawdowns for short horizons.
4) Maintain liquidity and buffers
– Keep a cash or short-term bond buffer to cover withdrawals for 1–3 years (bucketing strategy) so you aren’t forced to sell in a downturn.
– For retirees, plan withdrawal rates conservatively or use dynamic withdrawals (adjust spending when portfolio underperforms).
5) Diversify across uncorrelated assets
– Combine equities, fixed income, alternatives, real assets—different asset classes often decline at different times, lowering simultaneous drawdowns.
6) Rebalance systematically
– Periodic rebalancing (calendar or threshold-based) enforces “buy low, sell high,” which can help shrink long-term drawdowns and compound growth.
7) Use hedging selectively (advanced)
– Hedging with options or dedicated hedged allocation can limit downside but comes with costs and complexity—suitable for sophisticated investors or institutions.
8) Run stress tests and scenario analysis
– Simulate severe drawdowns and withdrawals to see potential outcomes and adjust plan if needed (e.g., southwestern scenarios and lengthened recoveries).
9) Monitor regularly and keep a plan for behavioral responses
– Establish rebalancing and review cadence (quarterly or semiannual).
– Define rules for when to change allocation or stop losses to avoid emotional decisions in crises.
10) Get professional help when needed
– Financial advisors can help translate drawdown tolerance into a practical allocation, withdrawal strategy, and tax-aware plan.
Practical checklist for retirees
– Calculate a sustainable withdrawal rate (understand limitations of “4% rule”).
– Create a short-term cash/bond bucket to fund withdrawals during market downturns.
– Choose a diversified, lower-volatility core portfolio.
– Consider annuities or guaranteed income for a portion of essential expenses.
– Revisit plan yearly and stress test for market shocks.
Monitoring and tools
– Many portfolio platforms and fund fact sheets report MDD and recovery times.
– Use spreadsheet calculations or portfolio software to compute rolling drawdowns, MDD and Ulcer Index.
– Compare funds using both return and drawdown statistics (e.g., risk-adjusted metrics that incorporate drawdowns).
Bottom line
Drawdowns offer a practical, outcome-focused measure of downside risk. They tell you how much an investment has historically fallen from peaks and how long it took to recover—information that’s especially important if you need funds soon or are withdrawing from a portfolio. Use drawdown metrics alongside return, volatility, and recovery-time assessments to build an allocation and withdrawal plan that fits your tolerance and timeframe.
Sources
– Investopedia, “Drawdown” (https://www.investopedia.com/terms/d/drawdown.asp)
– Peter Marin and Byron McCann, The Investor’s Guide to Fidelity Funds, Venture Catalyst, 1998.
– Schroeders Wealth Management, “How Stock Markets Perform After Heavy Falls” (source cited in original material)
If you’d like, I can:
– Compute historical drawdowns and recovery times for a specific fund or index (provide tickers and date range).
– Build a simple retirement withdrawal scenario that shows how different drawdown magnitudes affect portfolio longevity.