Meaning of Drawdown in Finance
Drawdown in Finance refers to how much an investment declines from the historical peak in a particular period and then regains its original position. In other words, how much an investment in a stock or a fund is down from its peak mark before it reaches back the peak position. It is a measure of downside volatility of investment whether in stocks or funds. It is also important for comparing the historical fund performance as compared to its peers or monitor the personal trading of individuals.
- A drawdown and a loss are two separate things since a drawdown is only a temporary decline in the value of the stock or the fund while loss refers to when the same stock or the fund is been sold at a price lower than the purchase price
- It is also referred to as the negative standard deviation in relation to the price of the stock.
- It is very common among hedge fund traders, Long term investors and market experts.
Below mentioned is the statistical formula used by statisticians to calculate the drawdown amount or % of a given stock or the portfolio.
- D(T) = Drawdown Time
- X = Variables
Examples of Drawdown Calculation
Below are the examples of Drawdown formula and calculations
Let us take the below-mentioned example to understand the drawdown for a portfolio: if $1,00,000 has been invested 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.
Solution : In this case, the fund value has decreased from $ 1,00,000 to $ 30,000 reflecting a 70% decrease. Since the fund has climbed back to $ 1,10,000 after one year. Here the drawdown will be recorded as 70% for the fund for all the future analysis. In this case, the upper limit of $10,000 will be ignored and the trough values will be compared with the peak values to compute drawdown risk%.
Mr. A has invested $ 10,000 at the beginning of the year and bought stocks. In a weeks time, there was a minor fall in the portfolio due to one stock underperforming because of which the portfolio value fell up to $9,000 which got received quickly. One year there was a sudden steep decline in the portfolio up to $6,000 due to one of the stocks becoming obsolete. After some months, the portfolio value increased to $11,000 due to one of the stocks overperformed and absorbed the losses from the obsolete stock.
Solution: In this case, the Drawdown of the portfolio will be recorded when the portfolio climbed back to $11,000 as $4,000 ( $10,000-$6,000 ) representing fall in the portfolio value and is the actual risk of the portfolio i.e the drawdown risk.
Advantages of Drawdown
It is one of the mathematical tools to derive the risk of the portfolio by comparing the peak and the trough values when the portfolio regains its original shape.
Below are some of the advantages :
- It gives the investor the sense of the risk that the portfolio or the stock holds before investment.
- A stock or the portfolio with a lower drawdown will give comfort to the traders or the investors to put their money and earn.
- It helps the trader or the investor to ascertain the volatility of the stock or the fund with the market and the industry in specific.
- It is used in decision making by large corporate since the ticket size of the investments are huge.
Disadvantages of Drawdown
- It is a relative method of calculating the drawdown % or the amount by just subtracting the trough value from the peak value of the stock or the portfolio.
- It can vary from stock to stock or fund to fund.
- Sometimes there is only a marginal fall in the stock or the fund due to some kind of market news or political stories. This downfall should not be considered as a drawdown since the value has decline merely because of the news element and there is no issue in the stocks in the portfolio.
- Traders may manipulate the stock in order to record the minimum drawdown of the fund and increase the fund performance.
Limitations of Drawdown
- Complicated if there is random variation in the stocks which are beyond the control.
- Difficult to compute in excel thereby declining the portfolio value.
- It ignores the government policies which may go against the company.
Points to Note
If there is a change in the drawdown % and amount i.e. If a 40% drawdown of a stock or the fund decreases to 20% drawdown, this reflects that the stock or the fund has started performing again and will soon reach the peak mark again thus reducing the downward risk in the stock or the portfolio. In order to have a low drawdown ratio for a portfolio, the same should be well-diversified among multiple stocks so that the losses of one cannot get the color of the others in the basket.
Drawdown is one of the most important and widely used mathematical technologies used by the analyst to analyze the performance of the stock or the fund or the fund based upon drawdown %. Investors will always prefer investing in a stock or the fund will lower drawdowns history in the past as it directly hits the performance of the fund managers.
Thus an investor will stay away from the stock or the fund whose historical drawdown is higher as compared to those whose historical background of the drawdown ie. the % and amount are higher too.
This has been a guide to what is Drawdown and its meaning. Here we provide you the formula to calculate drawdown along with examples, advantages, disadvantages, and limitations. You can learn more about financing from the following articles –