In investing, a drawdown refers to the percentage decline from an investment’s peak value to its lowest point before a recovery occurs. This metric provides valuable insight into historical risk, helping investors compare funds, evaluate performance, and assess portfolio stability over time.
For instance, if an investment portfolio worth $20,000 drops to $18,000 before rebounding to $20,000, the drawdown can be calculated as follows:
($20,000 - $18,000) ÷ $20,000 = 0.10, or 10%
Key Takeaways
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Drawdowns represent the percentage drop between an investment’s peak and trough, serving as a measure of downside volatility.
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The duration of recovery from a drawdown is as important as the size of the decline.
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A drawdown differs from a realized loss since it measures a temporary drop in value rather than an actual sale at a lower price.
The Fundamentals of Drawdowns
Drawdowns occur naturally during market cycles as prices fluctuate between highs (peaks) and lows (troughs). Investors often analyze these movements to understand an asset’s risk profile. One useful indicator is the Ulcer Index (UI), which quantifies downside risk by measuring both the depth and duration of declines.
A drawdown is typically confirmed once an asset or fund regains its previous peak. Until recovery occurs, the true depth of the drawdown remains uncertain, as further declines could extend the trough.
While standard deviation measures overall volatility, drawdowns specifically highlight downside performance—an especially important factor for investors who may need to withdraw capital in the short term, such as retirees. Some performance metrics, including Sterling ratios, use drawdowns to compare an investment’s potential reward against its historical risk.
Why Drawdowns Matter
The significance of a drawdown lies not only in how deep the decline is, but also in how long it takes to recover. Market conditions, investor sentiment, and the underlying fundamentals of a company or fund all influence the speed of recovery.
A 1% drawdown requires only a 1.01% gain to return to the previous peak. However, a 20% drawdown requires a 25% rebound just to break even. This asymmetric relationship illustrates why managing downside risk is crucial.
During market crises—such as the 2008 financial collapse—investors who sold during steep declines often missed out on the substantial rebounds that followed. For example, despite one-day losses of up to 9%, the stock market delivered cumulative gains between 70% and 147% over the next five years. Those who stayed invested benefited from the recovery, while those who exited locked in their losses.
Drawdown Risk for Retirees
For retirees and short-term investors, drawdowns can pose a greater challenge because they have less time to recover from significant market declines. These investors may want to determine their maximum acceptable drawdown (MDD)—the largest drop they can tolerate—before choosing specific funds or stocks.
A diversified portfolio is one of the most effective ways to limit drawdown risk. Holding a mix of assets such as stocks, bonds, commodities, and cash can reduce the chance that all investments experience simultaneous declines. This diversification provides income stability and allows retirees to avoid selling assets at unfavorable prices.
Important:
In retirement planning, the term “drawdown” can also refer to the process of withdrawing money from a retirement account. This is different from an investment drawdown, which measures market declines.
Example of a Drawdown Calculation
Consider an investor who purchases shares of XYZ Corp. at $100 per share. The stock rises to $110, then falls to $80 before recovering. The drawdown is calculated as follows:
($110 - $80) ÷ $110 = 0.273, or 27.3%
In this case, the investor experienced a 27.3% drawdown, but their unrealized loss was only $20 per share, since they bought at $100—not at the $110 peak. Later, if the stock climbs to $120 and then dips to $105 before recovering, the new drawdown would be:
($120 - $105) ÷ $120 = 12.5%
This demonstrates that drawdowns are dynamic and can occur multiple times as markets fluctuate.
The Bottom Line
A drawdown measures how much and how quickly an asset’s value declines from its peak before recovering. It offers a clear view of downside risk and recovery potential—key considerations for both short-term and long-term investors.
Investors with longer time horizons may tolerate larger drawdowns, allowing their portfolios more time to rebound. Those nearing retirement, however, often benefit from lower-volatility investments and diversified asset allocation. Understanding and monitoring drawdowns helps investors align their portfolios with their personal risk tolerance and financial goals.
Frequently Asked Questions
Q1: What is a drawdown in investing?
A1: A drawdown refers to the percentage decline from an investment’s peak value to its lowest point before a recovery occurs. It measures temporary downside risk, helping investors understand volatility and portfolio stability.
Q2: How is a drawdown calculated?
A2: Drawdown is calculated by subtracting the trough value from the peak value, then dividing by the peak value. For example, if a stock peaks at $20,000 and falls to $18,000:
($20,000 - $18,000) ÷ $20,000 = 0.10, or 10%.
Q3: Why are drawdowns important for investors?
A3: Drawdowns highlight downside risk and recovery potential. They are crucial for managing risk, planning withdrawals, and comparing investment performance, especially for retirees or short-term investors.
Q4: How does drawdown differ from a realized loss?
A4: A drawdown measures a temporary decline in value without selling, while a realized loss occurs when an asset is sold at a lower price than its purchase price.
Q5: How does the size of a drawdown affect recovery?
A5: Larger drawdowns require proportionally larger gains to recover. For example, a 20% drawdown requires a 25% gain to return to the previous peak, illustrating the asymmetric nature of losses and recovery.
Q6: How can investors manage drawdown risk?
A6: Diversification across asset classes, long-term investment horizons, and careful portfolio allocation help reduce drawdown risk. Retirees may also focus on lower-volatility investments to minimize impact.
Q7: Can drawdowns occur multiple times?
A7: Yes, drawdowns are dynamic. As markets fluctuate, assets can experience multiple peaks and troughs, creating successive drawdowns over time.
Q8: What is the difference between drawdown and retirement account withdrawals?
A8: In retirement planning, “drawdown” can also refer to withdrawing money from accounts. This differs from investment drawdowns, which measure market declines in asset value.