Updated: May 23, 2022
A drawdown is defined as a peak to trough decline in a stock, fund, or portfolio. For example, if you have a portfolio worth $100,000, and it declines to $80,000 before climbing back above $100,000, then your portfolio had a drawdown of 20%.
A drawdown is measured from peak to trough and is not recorded until the asset experiences a new peak. So in our previous example, if the portfolio stayed below $100,000, then a drawdown would not be recorded. It would not be until the portfolio value rose to at least $100,000.01 that the drawdown would be recorded.
Drawdown is important because an asset must experience a gain greater than its drawdown in order to recover any losses caused by the drawdown. For example, if an asset has a drawdown of 1%, it needs to increase by 1.01% to recover that loss. This relationship increases as the magnitude of the drawdown increases. An asset that loses 20% needs to increase by 25% to return to the previous peak. An asset that loses 50% needs to increase by an entire 100% to return to its previous value.
For this reason, many investors set a maximum drawdown (MDD) for their portfolios. Most investors will choose to cut their losses after a MDD of 15-20%.
Why does drawdown matter?
Drawdown, along with volatility, are two important metrics investors should consider. Some investors care even more about drawdown depending on their time horizon.
For example, if you are a young investor with many years before retirement, you be comfortable with a MDD of 20%+ because you have sufficient time to recover those losses. In this case, you may be comfortable with taking on more risk.
However, if you are closer to retirement, even a drawdown of 5-10% could hurt you given you might need to withdraw your money sooner. In this case, you would be more concerned with capital preservation than growth and should invest your money accordingly.
Regardless of your investment goals and time horizon, you should be considering drawdown when making investment decisions. Set your MDD based on your preferences and what you're comfortable with. Then, when evaluating stocks and/or funds, consider what drawdowns they experienced during different market periods. Oftentimes, you may find you have too much exposure to assets that have a higher potential for large drawdowns.