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Drawdown

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A drawdown is when the value of an investment, trading account, or fund goes down from its highest point to its lowest point during a certain time. It helps measure the risk of different investments, compare how well funds are doing, or keep track of personal trading performance. Drawdown is usually shown as a percentage, calculated by comparing the highest point to the lowest point. For example, if a trading account starts at $10,000 and drops to $9,000 before going back up to $10,000, it experiences a 10% drawdown.

Understanding Drawdowns

A drawdown is when an investment or trading account’s value goes down from its highest point and then goes back up again. The Ulcer Index (UI) keeps track of these ups and downs. It stays in place as long as the price stays below the highest point. In the example, if the account drops to $9,000 and then goes back up to $10,000, the drawdown is only 10%.

We use this method to track drawdowns because we can’t know how low it goes until it starts going back up again. As long as the price stays below the old highest point, it could keep dropping, making the drawdown even bigger.

Drawdowns help us understand how risky an investment is. The Sterling ratios use drawdowns to see how much reward we might get compared to the risks we’re taking.

Drawdown can also mean how much a stock’s price goes down from its highest point to its lowest. For example, if a stock goes from $100 to $50 and then goes back up to $100.01 or more, the drawdown was $50 or 50% from the highest point.

Stock Drawdowns

Investors often gauge a stock’s overall volatility using its standard deviation. However, many investors, particularly retirees who rely on pension and retirement accounts, are more focused on drawdowns.

For retirees, volatile markets and significant drawdowns can pose challenges. They pay close attention to the drawdown of their investments, whether in stocks or mutual funds and assess their maximum drawdown (MDD). This helps them potentially steer clear of investments that have experienced the largest historical drawdowns.

Risk of Drawdowns

Drawdowns pose a big risk to investors because of the effort needed for a share price to bounce back from a decline.

For instance, if a stock drops by 1%, it might not seem like a big deal since it only needs to rise by 1.01% to get back to its previous high. However, a 20% drawdown demands a 25% gain to return to the old peak. During the 2008-2009 Great Recession, a 50% drawdown meant the stock needed a whopping 100% increase to recover.

To manage this risk, some investors decide to steer clear of drawdowns greater than 20%. If they see such a decline, they might sell the stock and convert their position into cash instead.

Assessment of Drawdowns

Mitigating drawdown risk is usually achieved through maintaining a well-diversified portfolio and understanding how long it might take to recover. For those who are early in their careers or have more than 10 years until retirement, sticking to the 20% drawdown limit suggested by many financial advisors should be enough to protect the portfolio for a rebound.

However, retirees need to be extra cautious about drawdown risks in their portfolios. They may not have many years for the portfolio to bounce back before they start withdrawing funds. Diversifying a portfolio across various assets like stocks, bonds, precious metals, commodities, and cash instruments can provide some protection against drawdowns because different assets respond differently to market conditions.

Time to Recover a Drawdown

The severity of drawdowns is important in assessing risk, but so is the time it takes to recover from a drawdown. Different investments behave differently. For example, a 10% drawdown in one hedge fund or trader’s account might take years to bounce back.

In contrast, another hedge fund or trader might recover losses swiftly, restoring the account to its peak value in a short time. Therefore, it’s essential to consider drawdowns in relation to how long it usually takes for the investment or fund to recover from the loss.

Example of a Drawdown

Let’s say a trader buys Apple (AAPL) stock at $100. The price goes up to $110 (highest point) but then drops quickly to $80 (lowest point) before going back above $110. The highest price for the stock was $110, and the lowest was $80. When we look at drawdowns, we measure from the highest to the lowest point. So, the drawdown is 27.3%, which means $30 ÷ $110 x 100.

It’s important to note that a drawdown isn’t the same as a loss. Even though the drawdown for the stock was 27.3%, the trader would show an unrealized loss of 20% when the stock was at $80. This is because most traders think about losses based on what they paid for the stock ($100 in this case), not the highest price the stock reached after they bought it.

Now, let’s say the price goes up to $120 (highest point) and then drops to $105 before going up again to $125. The new highest price is $120, and the newest lowest price is $105. This means the drawdown is 12.5% or $15, calculated as $15 ÷ $120.

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