Drawdown

What is a drawdown?

A drawdown is the decline in the value of an investment from a peak to the subsequent trough, expressed as a percentage. It measures downside volatility and shows how much an investment has fallen before recovering to its prior high (if it does).

How to calculate drawdown

Formula:
Peak-to-trough drawdown = (Peak − Trough) ÷ Peak

Examples:
* An account falls from $20,000 to $18,000: drawdown = ($20,000 − $18,000) ÷ $20,000 = 10%.
* A stock peaks at $110 then falls to $80: drawdown = ($110 − $80) ÷ $110 ≈ 27.3%.

Note: Drawdown differs from an investor’s loss relative to purchase price. If the stock above was bought at $100, the unrealized loss at the $80 trough is 20%, not 27.3%.

Why drawdowns matter

• Risk measurement: Drawdowns capture downside moves that standard deviation may not emphasize. They are often used in risk-adjusted performance metrics and ratios that compare drawdown to returns.
• Recovery requirement: The larger the drawdown, the larger the percentage gain required to return to the previous peak. For example, a 20% decline requires a 25% gain to recover.
• Behavioral risk: Large drawdowns can prompt hasty selling; investors who exit during deep declines lock in losses and forgo recoveries.

Maximum drawdown (MDD)

Maximum drawdown is the largest peak-to-trough decline over a specified period. It’s a common summary statistic for historical downside risk and is useful when comparing funds or strategies.

Time to recovery

Drawdown magnitude is only part of the story—duration matters. Two investments with identical drawdowns can differ widely in how long they take to reach a new high. Recovery time depends on market conditions and the asset’s long-run performance.

Drawdowns and retirees

Short time horizons make drawdowns more consequential. Retirees who must withdraw income soon have less time to wait for recoveries, so they should:
* Determine the maximum drawdown they can tolerate.
* Compare funds’ historical MDDs before investing.
* Consider a diversified mix (stocks, bonds, cash, other assets) to reduce the chance of simultaneous deep declines across holdings.

Managing drawdown risk

• Diversification: Mix assets that don’t move together to reduce portfolio-level drawdowns.
• Time horizon alignment: Match asset risk to how long you can wait for recovery.
• Risk controls: Use stop-loss rules, rebalancing, or defensive allocations to limit exposure when appropriate.
• Understand strategy: Some strategies accept large drawdowns in pursuit of higher long-term returns; ensure this fits your goals and temperament.

Common metrics and tools

• Maximum drawdown (MDD): largest historical peak-to-trough decline.
• Ulcer Index: measures depth and duration of drawdowns (focuses on downside risk).
• Risk-adjusted ratios (e.g., Sterling ratio): compare return to drawdown-based risk.

Conclusion

Drawdown is a practical measure of downside volatility that helps investors evaluate historical risk and the potential recovery burden after declines. Consider both the size and duration of drawdowns when selecting investments, and align portfolio construction with your time horizon and tolerance for declines.