Drawdown - Why We Use It
The concept and term of drawdown may be new to many investors, but it is an important factor we at Provident use in our analysis of any investment strategy and within the portfolio as a whole. From a risk-management perspective, drawdown and the mathematics of winning and losing are closely related.
Drawdown is the decline in value from the peak to the trough over a specific time and is usually quoted as a percent. For example, if your investment amount was $100,000 and you lost $50,000, this would represent a 50% loss in value for your investments. Your account equity, the amount remaining, is $50,000 after the drawdown. You will need a gain of $50,000 to bring your investment back to $100,000.
How much gain do you need to bring your remaining investment back to original? If your answer is 50%, then it is wrong, because 50% of $50,000 (account equity after drawdown) is only $25,000, and that would take your account back to only $75,000. You would still be behind $25,000 from your initial investment. So the correct answer is 100%, that is, you will need a 100% return of the remaining $50,000 to bring your investment back to the original position. In summary, this simple example demonstrates that if you have lost 50% of your investment, in this case, then you need 100% gain to restore the financial position of your account to the original position.
The picture below is worth a thousand words and explains the concept very clearly for those of us who are more visually gifted. As you can see, the S&P 500 has suffered relatively large drawdowns over the last ten years, -49% and -57% from March of 2000 to October of 2002 and from October 2007 to March of 2009, respectively. Since no one has a crystal ball, we do not know what the peak or trough (top or bottom) will be until it is behind us.
Big drawdowns can take a long time to recover one's account back to the original principal amount. It took almost five years (5 years!) to recover from the drawdown of the the S&P 500 after the dot com bubble, and we have not fully recovered from the drawdown in the S&P 500 that bottomed out in March of 2009.
It is for this reason that active risk management is critical to long-term success when it comes to investing. Many of us, especially retirees, do not have five years to wait for our investments to get back to breakeven. There is also the lost opportunity of time, with respect to compounding the growth of capital and not just compounding the capital to get back to even.
Drawdown can be thought of in simple terms as one's pain threshold. If you have $10,000 and it dropped to $8,000 (20%), would you still be able to sleep at night? What if you opened your statement and it was down $5,000 (50% drawdown) in equity value? As drawdown is a percentage-based measure that one can directly associate with their investment account value, it provides a meaningful sense of the risk one is willing to accept. Since we have all lived through two drawdowns of approximately 50% in the last ten years, when looking at the S&P 500, we know what it feels like and how long it has taken to recover. When looking at investments, be sure to consider drawdown.
Disclaimers: Drawdown is a measurement tool, but is not the only risk-measurement tool. Historical drawdowns of and investment, index or strategy does not necessarily represent future drawdowns, performance or offer predictive value for what may happen in the future. No one on the planet has a crystal ball or can say that low drawdown or high drawn investment will continue to operate in the exact same manner.