A drawdown is the peak-to-trough decline of an investment or fund during a specific recorded period, commonly used to measure downside risk.
Understanding drawdowns
A drawdown measures the percentage drop from the highest historical price of an asset to its lowest price before a new high is reached. Financial analysts use this metric to evaluate the historical volatility of an asset. It provides a historical record of how much value an investment has lost during market downturns. Elephants tracking their portfolios use this data to assess whether an asset aligns with their personal risk tolerance.
There is a direct distinction between a standard drawdown and a maximum drawdown. A maximum drawdown represents the absolute largest percentage drop over a specific timeframe. Financial models use the maximum drawdown figure in risk-adjusted return calculations. Equations like the Calmar ratio and the Sterling ratio rely on maximum drawdown data to compare the performance of different funds.
The concept of a drawdown includes the dimension of time. A drawdown period begins when the price drops below a peak and ends when the price recovers to exceed that previous peak. The total duration of the drawdown contains the time it takes for the price to fall to the trough and the subsequent time it takes for the price to recover to the initial peak level.
Traders rely on historical drawdown data to establish capital limits and expectations. If an equity fund has a historical maximum drawdown of 50 percent, an investor must be prepared for the possibility that their capital could halve in value. Recognizing these historical patterns prepares investors for standard market corrections.
Example
An Elephant purchases shares in the Global Peanut Export Fund at 100 per share. Over the next six months, the share price rises to a high of 150. This price of 150 is the peak. Due to unexpected weather patterns affecting peanut yields in Argentina and Senegal, the fund value steadily drops over the following year until it hits a low of 90. This price of 90 is the trough. The share price eventually recovers and surpasses 150 two years later. The drawdown is measured from the peak of 150 to the trough of 90. This represents a 60-point decline. To calculate the drawdown percentage, the 60-point decline is divided by the peak price of 150, resulting in a drawdown of 40 percent.