Although the degree of volatility may vary, the financial markets are in constant flux. To assess how well your portfolio is performing, you need efficient tools that can quantify the impact of such market movements on your investments. One such metric is the drawdown, which measures the potential risk in an asset or a portfolio.
In this article, we examine the meaning of a drawdown, how you can calculate it, and how it is useful in risk assessment.
What is a drawdown in trading
The term drawdown refers to the difference between the highest point and the subsequent lowest point in an asset’s price over a defined period. It is recorded once the price of the asset crosses its previous peak.
For instance, say the price of a stock reaches a new high (point A) today. Over the next few days, it falls to a new low (point B). Thereafter, the price rises again, this time shooting past its previous peak (point A). Once this happens, you can record the drawdown — which is the difference between the highest peak (point A) and the subsequent lowest point (point B).
Remember that the drawdown in trading is different from the loss from a trade. The latter is calculated as the difference between the purchase and sale prices. At the same time, the former is the difference between the highest and lowest prices of an asset over a defined period.
How to calculate a drawdown
The drawdown in trading and investing can be expressed as an amount or percentage. To calculate and express the drawdown in any of these ways, you can use the formulae shown below.
Drawdown (in amount) = Maximum price — Minimum price Or Drawdown (in percentage) = [(Maximum price — Minimum price) ÷ Maximum price] x 100 |
An example of a drawdown in investment portfolios
Let us discuss a hypothetical example to better understand how to use the formulae for expressing the drawdown as an amount or a percentage,
Say you have a portfolio of investments that is currently valued at Rs. 10,000. Over the course of the next month, let us say the portfolio value fluctuates as follows:
- Day 9: The portfolio value rises to a peak of Rs. 13,000 and then begins to fall.
- Day 18: The portfolio value dips to a trough of Rs. 8,500 and then begins to rise.
- Day 30: The portfolio value hits Rs. 14,000 (thus crossing the previous high on day 9).
So, on day 30, when the value of the portfolio crosses the previous peak, a drawdown can be recorded. Substituting the values for the maximum and minimum prices, we get the following values for the drawdown in amount and percentage.
Drawdown (in amount):
= Maximum price — Minimum price
= Rs. 13,000 — Rs. 8,500
= Rs. 4,500
Drawdown (in percentage):
= [(Maximum price — Minimum price) ÷ Maximum price] x 100
= [(Rs. 13,000 — Rs. 8,500) ÷ Rs. 13,000] x 100
= [Rs. 4,500 ÷ Rs. 13,000] x 100
= 34.61%
Decoding the significance of drawdowns
Drawdowns are crucial for evaluating the risk associated with a particular stock, security or investment portfolio. Typically, a drawdown in trading or investing gives you a better idea of the potential loss an investment may cause by calculating the difference between the maximum possible profit (or peak) and the maximum possible loss (or trough) over a given period.
This peak-to-trough decline is significant for assessing the volatility and risk profile of an asset. When you understand the drawdown, you can make a more informed decision about whether or not you can afford to take on the volatility associated with an investment option. It also allows you to set more realistic expectations about the volatility and potential losses you can expect from your investment or portfolio.
By factoring in the drawdown when you make an investment decision, you can ensure that your strategy is more resilient to turbulent phases in the market. However, it is crucial to note the difference between losses and drawdowns.
You can have a net profit in your portfolio even when there has been a drawdown. For instance, your portfolio value may rise from Rs. 10,000 to Rs. 60,000 and then dip down to Rs. 40,000. This translates to a drawdown of Rs. 20,000 even though your net profit is still Rs. 30,000.
Assessing drawdowns to minimise portfolio risks
To check the drawdown before making an investment or to track the drawdown for the assets in your portfolio, it helps to have some guidelines. Here are some pointers to make it easier for you to assess the drawdown and minimise portfolio risk. You can adopt these guidelines to understand how risky your investments are and take measures to reduce the potential for loss as needed.
- The extent of the drawdowns: Check the magnitude of the drawdown to get a better idea of the worst-case scenario during a specific period. Larger drawdowns indicate higher risk.
- Frequency of the drawdowns: If the drawdowns are more frequent, it indicates the asset or portfolio is highly volatile. This increases the overall risk.
- Duration of the drawdowns: In a long drawn-out drawdown, it takes longer for the price to recover after a decline. This may be a problem if you have a short-term outlook.
- Benchmark comparison: You can compare the drawdown in your preferred asset or portfolio to that in a benchmark index or peer stocks/securities.
- Risk-adjusted returns: Use the drawdown information along with other metrics like Sharpe ratio and downside analysis to get a better idea of the risk-adjusted returns.
Conclusion
While the drawdown is an important metric, it is not the only aspect you need to account for before you make an investment decision. You must also look into elements like the standard deviation, beta, and other technical indicators to evaluate the volatility associated with an existing or potential investment or asset.
