Drawdown

A drawdown is defined as the percentage of decline in the value of a security over a period before it bounces back to the original value or beyond. It is expressed as the difference between the highest, i.e., the peak value of that asset, and the lowest, i.e., the trough value of the same. Calculating the drawdown value helps investors identify the risks associated with a particular investment and accordingly prepare themselves to manage it.

While a drawdown instance is a common phenomenon when observed to a certain limit, investors' portfolios are adversely affected when the limit is crossed. The more the dropdown, the harder it is for an investment or trading account to bounce back to a normal level.

• A drawdown is a tool that helps traders assess the percentage of risk associated with an investment, be it a fund, stock, or trading account.
• The concept finds relevance in different sectors, including banking, mortgage, stock market, forex, etc.
• With the help of this tool, investors get an opportunity to be aware of what worst can happen if they make an investment and thereby help them manage their financial assets accordingly.
• The percentage of decline in the value of a stock, fund, or portfolio can be misleading in some situations, given the fake market news and traders' manipulative measures. 

The drawdown of funds or trading accounts allows investors to understand the extent to which the value of an investment could decline before it recovers its original position or value. For example, it is quite normal to witness a decline of 20% in the value of an investment, given the market fluctuations from time to time. However, investors need to worry if the downward movement from peak to trough exceeds that limit and shows a 40%-50% drawdown or above.

With the increase in the difference between the peak value of an investment and its trough, the drawdown deepens. And as the gap widens, it becomes tougher for that investment to bounce back to its original value. The same applies to drawdown in forex.

Investors use the drawdowns to analyze the historical set of trading data and identify the warning signs that the declining value of any investment exhibits. In addition, these also let them track and compare the performances of different funds and other trading instruments. The peak and trough difference enables individuals and firms to enjoy efficient asset management by detecting the risks associated with securities.

Let us consider the following examples to understand the entire process of drawdown calculation:

Example #1

Stephens invested $1,00,000 in a fund at the beginning of the year. At the year-end, the fund value decreases to $30,000, and then eventually, after one year, it goes back to $1,10,000.

In the first instance, the fund value decreases from $ 1,00,000 to $ 30,000, which reflects a 70% decrease. Though after a year, the fund value bounces back to $1,10,000, the drawdown recorded for that investment would be considered 70% in all the future analyses.

Example #2

Katherine invests $ 10,000 to buy stocks at the beginning of 2019. Within a week, there was a minor fall in the portfolio due to the underperformance of one stock, which took the value down to $9,000. Then, in 2020, there was a sudden steep decline of up to $6,000 in the portfolio as one of the stocks turned obsolete. 

During mid-2020, the portfolio value recovered and increased to $11,000, given the sound performance of a stock. This absorbed the losses incurred from the obsolete stock.

In this scenario, the portfolio's drawdown will be recorded as per the decline in value before the portfolio climbed back to $11,000. Thus, the drawdown here is $4,000 ( $10,000-$6,000 ) i.e., 40%, signifying the actual risk associated with the portfolio.

Drawdown trading is a significant way of assessing the risk associated with a portfolio. When the possible risks are known, investors can make investment decisions accordingly. They would have all the cards open in front to determine whether investing in a fund or trading account would be a good idea. 

Let us have a quick look at the benefits that this trading tool has to offer:

• Investors are aware of the risks associated with the funds or trading accounts beforehand. Hence, they prepare themselves accordingly to manage the same.
• Studying the historical drawdown analyses helps individuals and firms understand the trade pattern. As a result, they remain informed of the lower peak-trough difference. As a result, they put their money for significant returns in accordance with their expectations.
• Investors make investment decisions keeping the major risks in mind. If they know they can bear the losses to an extent, they proceed or skip it.
• The volatility of the stocks can easily be assessed with respect to the market or industry.

Besides the benefits, this trading tool has some limitations also. Here is a list of a few of them.

• The percentage varies from one stock, fund, or trading account to another.
• The degrading value might result from negative news or political stories that do rounds in the market. In such situations, falling prices are just a temporary phenomenon. Hence, the results might be misleading sometimes.

• Traders may manipulate the stock to record the minimum drawdown for a fund or trading account. This is done to mislead the market by faking the positive fund performance.
• It isn't easy to figure out if there is random variation in the stocks beyond the control.

This is a guide to what is Drawdown, its meaning, and its benefits. Here we explain its relevance in trading, forex, and banking along with examples. You can learn more about financing from the following articles –

• Hedge Ratio
• Herfindahl-Hirschman Index
• Quantamental Meaning
• Mutual Funds vs ETFs
• Profit Taking