A drawdown is an investment term that refers to the decline in value of a single investment or an investment portfolio from a relative peak value to a relative trough. It is an important risk factor for investors to consider, becoming more important in asset management in recent years.
A drawdown is commonly referred to as a percentage figure. For example, if the value of an investment portfolio declines from $10,000 to $7,000, then the portfolio has experienced a drawdown of 30%.
Two key elements must be looked at in relation to a drawdown. The first is money, and the second is time. The element of money refers to the monetary amount of the drawdown. The time element refers to how long the drawdown lasts – that is, what period of time elapses before the value of an investment recovers the drawdown amount, rising to a new relative peak value.
A drawdown is an investment term that refers to the decline in value of a single investment or an investment portfolio from a relative peak value to a relative trough.
A drawdown is an important risk factor for investors to consider.
The two elements of a drawdown are the monetary amount of the drawdown and the period of time required for an investment to recover from the drawdown.
Why Drawdown Matters – Money
The risk factor of drawdown is essential for investors to consider, but, unfortunately, it is often overlooked.
Why is drawdown so important? To answer that question, let’s look at a couple of example investor situations and how a drawdown may affect them.
Suppose you’re considering implementing a new trading strategy that has historically proven to be quite profitable overall, with average annual returns on investment of more than 20%. It sounds great, right? However, after looking at the past track record of using the strategy, you see that the strategy has experienced drawdowns in the amounts of $6,000, $7,000, and on one occasion, even $10,000. Nonetheless, the strategy has been profitable overall, taking a hypothetical starting investment of $5,000 to over $25,000 in a period of four years.
The drawdowns are still critical to consider for the following reason: Assume that you begin trading using the strategy, with a starting investment of $5,000, and happen to be unfortunate enough to begin trading the strategy at a time when it begins to experience one of its drawdown periods. If the drawdown matches just the lowest previous drawdown amount of $6,000, then your initial investment of $5,000 will be totally wiped out before you can enjoy the benefits of the strategy’s overall success.
Why Drawdown Matters – Time
This second example of how drawdown matters looks at the time element that must be considered – the amount of time that it takes for an investment to recover drawdown losses and move to a new relative high value.
Assume that you are considering investing in a mutual fund. The mutual fund’s performance is excellent overall, and the fund has not experienced excessive drawdowns in value. Over the previous seven years, the fund has only experienced two significant drawdowns – one of 10% and one of 20%.
However, when drawdowns have occurred, they have lasted for an extended period of time – on average, about 18 months. In other words, when a significant decline in the mutual fund’s net asset value (NAV) has occurred, it has taken approximately a year and a half for the fund to recover the loss and rise to a new high.
Now, suppose that when you invest in the fund, you anticipate needing to cash in your investment one year from now when you will have some large expenses to cover. If the fund experiences a drawdown of 10% following your investment in it, then, based on past performance, it is unlikely that the fund’s value will recover before you need to sell your shares.
Thus, you may be forced to liquidate your position in the fund at a loss. Being aware of this, you may wish to consider investing in an alternate fund whose past history shows a more rapid recovery, with shorter periods of drawdown.
Potential drawdown is an important factor for investors to consider, either in relation to an individual investment or their total investment portfolio. The two examples above illustrate why both the amount and duration of drawdowns are key elements to take into account.
Investors can minimize the investment risk posed by potential drawdowns by utilizing asset allocation management in their investment portfolio. For example, drawdowns in equity investments can be partially offset by investments such as bonds that offer a guaranteed, ongoing positive return on investment.
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