Drawdown

Before you rely on it

What to check

Measure from the peak, not from your purchase price.

The common error

Where people go wrong with drawdown

Confusing the two. Someone who bought after a run-up has a smaller loss than the drawdown suggests, and someone who bought at the top has exactly the drawdown, and they will draw opposite conclusions from the same headline.

Worked through

Drawdown in plain numbers

A portfolio rises to $120,000 and then falls to $84,000 before recovering; the drawdown at the bottom is ($120,000 − $84,000) ÷ $120,000, which is 30%. To get back to $120,000 from $84,000 you need a gain of 42.9%, because the base is smaller. If the account later climbs to a new peak of $140,000 and dips to $126,000, that is a 10% drawdown from the new high; the measure resets at every new peak. Drawdown tells you how it felt to hold the investment at its worst, which a yearly return can hide.

Easily confused

Drawdown and its neighbours

Drawdown is a decline from a peak, not a loss from your purchase price. You can be up on your investment and still be in a drawdown from a high; it is different from volatility, which measures the spread of returns in both directions, and from a bear market, which is a decline of twenty percent or more in a market index. Maximum drawdown is the largest such decline over a period. Drawdown duration adds how long it took to recover. Two funds with equal returns can have very different drawdowns.

In real decisions

Where drawdown turns up

Investors and advisors use drawdown to judge whether a strategy is tolerable. Someone who cannot sit through a 30% decline should not hold an allocation that has shown one. Fund managers report it alongside returns; retirees use it to plan withdrawals, since selling during a deep drawdown locks in losses. Risk teams set drawdown limits for traders. Comparing a fund's worst decline with the market's shows whether it protected capital in bad times.

Know the edges

Where drawdown stops being reliable

Drawdown is measured on history, so a future decline can be larger than any seen. Its size depends on the period chosen and the frequency of data. Daily data show deeper troughs than monthly data. It says nothing about how often declines occur. A single number cannot capture the whole risk; use it together with volatility, recovery time and your own capacity to hold through losses.

Quick answers

What people ask about drawdown

How is drawdown different from a loss? A loss is measured from your purchase price. Drawdown is measured from the latest peak, whenever it occurred. You can be up overall and still be in a drawdown.

What drawdown should I be ready for? Stocks have fallen thirty to fifty percent or more in bad periods. Ask how you would react to a fall of that size and whether your allocation lets you hold on.

How long does recovery take? It varies widely, from months to several years. A fall of 50% needs a gain of 100% to recover, which helps explain why deep drawdowns take long.