What Are Drawdowns And How To Avoid Them

A Drawdown is a peak-to-trough (highest-to-lowest continuous point) decline in the price of an investment, fund or commodity. Drawdowns are usually quoted as a percentage within a specified time period, and are used to measure the risk and volatility associated with an investment.

Understanding drawdowns helps investors assess the potential depth and duration of losses, enabling them to make more informed decisions and develop strategies to mitigate risks across multiple types of securities, including (but not limited to) stocks, bonds, or real estate.

On the below graph, for example, we can see Drawdowns as highlighted in red.

A Drawdown is caused when the trading price of an asset decreases. Within the context of the stock market, a drawdown can be triggered by various factors, each influencing the value of investments in different ways. Understanding these causes is crucial for investors aiming to manage risk and safeguard their portfolios. Here are some common causes of drawdowns:

1. Market Volatility: Fluctuations in the stock market, driven by factors such as economic data, geopolitical events, or changes in interest rates, can lead to significant drops in asset prices.
2. Economic Conditions: Recessions, inflation, unemployment rates, and other economic indicators can impact investor sentiment and result in a decline in investment values.
3. Corporate Performance: Poor earnings reports, management changes, product recalls, or any negative news related to a company can cause its stock price to fall, contributing to a drawdown in a portfolio.
4. Political Instability: Political events like elections, policy changes, trade wars, or international conflicts can create uncertainty, causing investors to sell off assets and leading to drawdowns.
5. Interest Rate Changes: Central banks’ decisions to raise or lower interest rates can affect investment values. Higher interest rates can lead to reduced spending and lower corporate profits, causing stock prices to decline.
6. Investor Behavior: Panic selling, herd behavior, and overreactions to news can drive market prices down sharply, contributing to drawdowns.

It’s vital to pay attention to Drawdown percentages. Loss of capital percentage is not equal to the capital gain percentage required to recoup the losses. Here’s a table which highlights both sides of the equation, where you can see that you need to earn more to recoup a loss.

To better understand why this is the case, let’s consider a simple case-study. We’ll use ‘moments’ as a shorthand for a given timeframe, as a drawdown could last as little as half an hour, or as long as a full decade (or longer!)

Moment One: Derek has $1,000, but a 20% Drawdown leaves him with $800.

Moment Two: Since Derek now has $800, he needs to increase this by 25% in order to get back to the original investment amount.

Let’s take a look at the numbers involved here:

Moment One: $1,000 – $200 = $800 (-20%)

And to check that we have our percentages correct to get Gabe back to his original investment…

Moment Two: $800 + $200 = $1,000 (+25%)Remember, on the second moment we’re not looking at the number of the original investment – Gabe no longer has that capital! So we have to look at the number he now has, after the Drawdown.

The further down the chart we look, the more percentage gain is required to recoup each loss. While a 10% loss of capital may not seem too debilitating, a 30% loss of capital begins to look increasingly unlikely to regain, and a 50% loss of capital results in the necessity for a 100% return… just to get back to where the portfolio started!

Not only is it painful to try and recoup such losses, but the resulting anxiety may lead to sleepless nights, continuous worry, and poor, emotionally-driven additional investment decisions. This is why minimising Drawdowns is so important – to avoid getting into such situations in the first place – for the long-term investor, smaller Drawdowns can have a bigger effect on the overall portfolio value than increases in stock value. Indeed, ‘he who loses least, wins most’.

Here are a few other reasons why Drawdowns are important for investors to keep a mindful eye on.

1. Risk Assessment: Drawdown percentages help investors understand the potential downside of their investments. By knowing the maximum loss experienced, investors can assess the riskiness of an asset and make more informed decisions.
2. Performance Comparison: Drawdown percentages allow investors to compare the performance of different investments or portfolios on a common scale. This comparison is crucial for evaluating which investments are more resilient during market downturns.
3. Psychological Comfort: Understanding drawdown percentages can prepare investors mentally for potential losses, reducing panic during market downturns. Knowing the historical drawdowns can offer peace of mind and prevent impulsive selling.
4. Investment Strategy: Drawdown data helps in crafting investment strategies that align with individual risk tolerance. Investors can choose investments that match their ability to endure losses without compromising their financial goals.
5. Recovery Time Analysis: The drawdown percentage, combined with the time it takes to recover, provides insights into the resilience and recovery capability of an investment. This can be critical for retirement planning and other long-term financial goals.
6. Fund Management Evaluation: For those investing in mutual funds, ETFs, or hedge funds, drawdown percentages are an important metric for evaluating fund managers’ performance. Funds with lower drawdowns are often seen as being managed more prudently.
7. Diversification Effectiveness: Monitoring drawdown percentages can help in assessing the effectiveness of a diversified portfolio. If diversification strategies are working, the overall drawdown should be minimized compared to individual investments.

Absolutely. Let’s take another look at the first graph, now with a different element highlighted:

We can see that this graph follows an upward trend – the overall growth goes from 470 (month 1) to 1,000 (month 33). Over this time, however, we can see that there are numerous Drawdowns; some of which take longer to recover than others. For example, after the Drawdown in month 11, it isn’t until month 21 that the price point is restored. (This could also be referred to as a ‘ten month Drawdown’).

A Maximum Drawdown is the all-time high to all-time low (peak to trough) as a percentage of an asset’s value, within a certain chronological time period. For example, on the graph we’ve been looking at, the Maximum Drawdown (based on the graph’s full time period from month 1 to month 33) is highlighted as below.

We can see that although there was a slight increase between months 25-26, this did not result in the graph recouping its losses, and therefore does not count as a ‘reset’ of the maximum drawdown.

Maximum Drawdown percentage can be calculated using the following formula:

(Trough Value – Peak Value) / Peak Value

(800 – 1050) / 1050 = -23.8%

Even this shallow-looking trough requires 31.25% gain in order to just get back to the same point!

Maximum Drawdown cannot be measured until the full end of the Drawdown occurs (a new peak). As we’ve seen before, recovery periods can vary wildly. Generally speaking, the shorter the recovery period, the better the security’s performance.

By focusing on strategies to reduce the severity and duration of drawdowns, investors can achieve more stable and potentially more profitable outcomes. Here are several compelling reasons to prioritize drawdown mitigation:

Significant drawdowns can be difficult to recover from and may require substantial gains to return to the original investment level.  Having years of patience and careful calibration wiped out by a single Drawdown (which may in turn take years to resolve) is frustrating when taking into account the opportunity cost of time used, and the capital itself.

By reducing losses in the first instance, investors can safeguard their capital, ensuring that it remains available for future investment opportunities.

Which is a better amount to invest at the very start of a bullish market – $5,000 or $6,000? It doesn’t matter that the difference is small; the correct answer is obvious.

Starting strong in bullish markets (thanks to the capital maintened as a result of risk management and mitigation), gives investors an important head-start on their overall investment goals. What may start off as a small difference in initial investment amount has the opportunity to grow into a massive advantage a couple of years down the line thanks to compounding.

Investments with smaller and less frequent drawdowns tend to have smoother performance over time. This consistency can be particularly appealing to long-term investors and those relying on their portfolios for income, as it reduces the psychological stress associated with volatile markets.

Severe and prolonged drawdowns can undermine an investor’s confidence and lead to panic-induced decisions, such as selling at the bottom of the market. By managing drawdowns, investors can maintain a more composed and disciplined approach, improving their overall investment decision-making.

Investors often seek not just the highest returns, but the best returns relative to the risk taken—known as risk-adjusted returns. By mitigating drawdowns, investors can improve the risk-adjusted performance of their portfolios, achieving a better balance between risk and reward.

Unfortunately, the only sure-fire way to prevent Drawdowns 100% of the time is to not participate in the stock market in the first place. There are, however, ways to manage and mitigate the risk of capital loss as a result of market Drawdown.

The difference between Risk Tolerance and Risk Capacity lies in an investor’s emotional response to risk (tolerance) versus their ability to absorb any losses without their lifestyle being affected (capacity). While these do not work to mitigate Drawdowns, they are still important for considering how important the overall preservation of capital is to an investment strategy (even sometimes at the ‘risk’ of not realizing as much gain).

One way of dealing with Drawdowns is to have a long time-horizon for investments (around ten years). During this time, any Drawdowns are much more likely to trend back upwards and recoup losses.

Those with shorter time horizons (for example investors who are just about to enter, or are already in, retirement), are the hardest hit when Drawdowns occur, as they lack the flexibility of being able to wait for markets to pick up again. In such cases, available liquidity is a problem.

This is the process by which we invest in different asset classes in order to minimise risk, as different assets will react in different ways to the same event. If a Drawdown occurs across one asset class, other asset classes may remain the same, or even improve, thus potentially mitigating the effects of the Drawdown.

Similar to diversification in that this is a way to spread risk, Hedging usually involves investing in assets with a negative covariance (for example, ice creams and umbrellas). This is used as a way of isolating risk to certain variables and follows the basic assumption that if one performs badly, the other has a good chance of performing well.

This type of asset is expected to retain or even increase its value during a turbulent (or bear) market. They are commonly used in order to limit exposure to drawdown losses. Importantly, however, Safe Haven assets change over time as markets evolve, and so any investment therein may alter as a result of this.

Regular, but not obsessive, monitoring of the state of an investment also plays a role in reducing Drawdowns. While an investor may miss opportunities and create unnecessary further costs if investments are changed on a whim, a certain level of engagement is necessary for accountability and understanding other opportunities or dangers. The ability to understand huge amounts of data and then act on the facts at a moment’s notice comes from making the most of tools such as InvestingPro in a seamless and transparent way.

Fear and greed are the enemies of sound financial strategy. Avoiding the desire to jump out of the market when it’s already going through a Drawdown is vital to keeping your investment goals in sight. It’s tough for humans to ignore their gut reactions, but not so much for algorithms. This is why the use of (transparent) AI investing models is important – not only for their ability to process vast amounts of information, but also to keep financial modelling and methodology consistent across securities and timeframes.

By understanding the concept and causes of drawdowns, investors can better assess the risks associated with their portfolios and make more informed decisions. Recognizing the importance of mitigating drawdowns not only preserves capital but also ensures smoother returns, enhances the power of compounding, and helps a portfolio to meet long-term financial goals.

Through diligent risk management, strategic diversification, and maintaining a disciplined approach, investors can navigate market volatility with greater confidence. The key to long-term success lies not just in seeking high returns, but in effectively managing the risks along the way.

Drawdowns occur due to factors such as market volatility, economic conditions, poor corporate performance, political instability, natural disasters, changes in interest rates, and investor behavior. These factors can lead to a decline in the value of investments.

The duration of drawdowns varies widely depending on the underlying causes and the type of investment. Some may last only a few days or weeks, while others, especially those caused by economic recessions, can extend for months or even years.

While they’re almost impossible to predict, investors can analyze market trends, economic indicators, and historical data to assess potential risks. Diversification and risk management strategies can help mitigate the impact of unexpected drawdowns.

A “good” drawdown percentage depends on the investor’s risk tolerance and investment strategy. Generally, a lower drawdown percentage indicates a less risky investment. A drawdown of less than 10% may be considered acceptable for conservative investors, while more aggressive investors might tolerate higher drawdowns.

Long-term investments can withstand periodic drawdowns, as markets generally recover over time. However, severe or prolonged drawdowns can impact the compounding effect and delay reaching financial goals. Managing them is therefore crucial for long-term investment success.

To mitigate drawdowns, diversify your investments across different asset classes, sectors, and geographical regions. Employ risk management strategies, such as setting stop-loss orders, maintaining adequate liquidity, and regularly reviewing and adjusting your portfolio.

No, as they vary across different types of investments. Stocks and commodities may experience more significant and frequent drawdowns compared to bonds or real estate. Each asset class has its unique risk and volatility profile, affecting the nature of drawdowns.

Historical drawdowns provide insights into an investment’s risk profile and how it has performed under various market conditions. Analyzing past drawdowns helps investors understand potential vulnerabilities and make informed decisions to adjust their future investment strategies accordingly.

Maximum drawdown refers to the largest peak-to-trough decline observed in an investment’s value over a specific period. It is important because it highlights the worst-case loss scenario, helping investors gauge the riskiness of an investment and plan their risk management strategies.

No, it is virtually impossible to fully avoid drawdowns in investing, as markets are inherently volatile. However, implementing robust risk management and diversification strategies can help minimize their severity and frequency.

Staying calm involves focusing on your long-term investment goals, understanding market cycles, and maintaining a diversified portfolio. Consulting with a financial advisor and sticking to a disciplined investment strategy can also help alleviate anxiety.