Drawdown
Drawdown measures the decline from a portfolio’s peak to its lowest point, revealing downside risk and the depth of potential losses.
What Is Drawdown?
Drawdown is a key risk metric that quantifies the decline in value of an investment or portfolio from its highest point (peak) to its lowest point (trough) before a new peak is reached. It is typically expressed as a percentage and provides insight into how much an investor could lose during adverse market conditions.
How Does Drawdown Work?
Drawdown is calculated by subtracting the trough value from the peak value, then dividing by the peak value and multiplying by 100 to get a percentage. For example, if a portfolio drops from $10,000 to $7,000 before recovering, the drawdown is 30%. The duration of a drawdown, the time it takes to recover to the previous peak is also important, as longer drawdowns can be more challenging for investors to endure.
Why Is Drawdown Important for Investors and Fund Managers?
Drawdown is essential for understanding downside risk and volatility. It helps allocators and managers assess how a strategy behaves during challenging periods and whether it aligns with their risk tolerance. Large or frequent drawdowns may signal poor risk management or overexposure, while smaller, infrequent drawdowns suggest a more resilient approach. Comparing drawdowns across funds or strategies helps investors evaluate stress resilience and risk-adjusted performance.
Example: Drawdown in Practice
Suppose an investor’s account grows to $20,000, then falls to $18,000 before recovering. The drawdown is $2,000, or 10%. If it takes six months to recover, the drawdown duration is six months. In another scenario, a fund drops from $10,000 to $6,000, then rebounds to $11,000, the drawdown is $4,000, or 40%, and is only recorded once the fund exceeds its previous peak.
When Should You Monitor Drawdown?
Drawdown should be monitored:
During strategy review and mandate negotiations
When comparing managers or funds
As part of ongoing risk management, especially in volatile or uncertain markets
Alongside other metrics like Sharpe Ratio, Value at Risk (VaR), and Equity Protect (EP) systems to get a holistic view of risk
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