Investopedia: What is a 'Drawdown'?

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Drawdown
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What is a 'Drawdown'

A drawdown is the peak-to-trough decline during a specific recorded period of an investment, fund or commodity. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Those tracking the entity measure from the time a retrenchment begins to when it reaches a new high.
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BREAKING DOWN 'Drawdown'

This drawdown method of recording is useful because a valley can't be measured until a new high occurs. Once the investment, fund or commodity reaches a new high, the tracker records the percentage change from the old high to the smallest trough. Drawdowns help determine an investment's financial risk. Both the Calmar and Sterling ratios use this metric to compare a security's possible reward to its risk.

Drawdown is simply the negative half of standard deviation in relation to a stock’s share price. A drawdown from a share price’s high to its low is considered its drawdown amount.
Stock Drawdowns

A stock’s total volatility is measured by its standard deviation, yet many investors, especially retirees who are withdrawing funds from pensions and retirement accounts, are concerned about drawdowns. During volatile markets, and markets that have a possibility of a correction, drawdown is a serious concern for retirees. Many are starting to look at the drawdown of their investments, from stocks to mutual funds, and considering their possible maximum drawdown (MDD) potential.
Drawdown Risk

Drawdowns present a significant risk to investors when considering the uptick in share price needed to overcome a drawdown. For example, it may not seem like much if a stock loses 1%, as it only needs an increase of 1.01% to recover to its previously held position. However, a drawdown of 20% requires a 25% return, while a 50% drawdown – seen during the 2008 to 2009 Great Recession – requires a whopping 100% increase to recover the same position. Most investors want to avoid drawdowns of 20% or greater before cutting their losses and turning a position into cash investments.

Retirees in particular feel this risk, if they are doubling down on the drawdown economics as they withdraw further funds from the principal of their investments to fund their retirements. In many cases, a drastic drawdown, coupled with continued withdrawals in retirement can shorten retirement funds considerably.
Drawdown Assessments

Typically, drawdown risks are mitigated by having a well-diversified portfolio and knowing the length of the recovery window. If a person is early in his career or has more than 10 years until retirement, the drawdown limit of 20% that most financial advisors expound should be sufficient to shelter portfolios for a recovery. However, retirees need to be especially careful about drawdown risks in their portfolios. Diversifying a portfolio across stocks, bonds and cash instruments can offer some protection against a drawdown, as market conditions affect different classes of investments in different ways.

Stock price or market drawdown should not be confused with retirement drawdown, which refers to how retirees should withdraw funds from their pension or retirement accounts.
Next Up Drawdown Percentage

    Drawdown
    Drawdown Percentage
    Maximum Drawdown (MDD)
    MAR Ratio
    Peak-To-Valley Drawdown
    Sterling Ratio
    Roboretirement
    Credit Sweep
    Risk Management
    Possibility Of Failure (POF) Rates

Drawdown Percentage
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The portion of a retirement account that a retiree withdraws each year. If the drawdown percentage is too high, the retiree will outlive her savings and struggle financially at the end of her life. If the drawdown percentage is too low, the retiree will die with money left over. Many people wish to spend most or all of the money they’ve worked so hard to earn and invest during their lifetimes. Others want to make sure they leave an inheritance for their spouse, children or charities they support.
BREAKING DOWN 'Drawdown Percentage '

A common suggestion for the ideal drawdown percentage is 4% of principal annually, adjusted for inflation. This 4% rule is supposed to maximize one’s chances of having enough money to last through to the end of one's life. A drawdown percentage of 4% is based on historical investment performance of a portfolio made up of 50% bonds and 50% stocks, and historical inflation rates. It is expected to ensure that the retiree’s nest egg lasts a minimum of 33 years and a maximum of 50-plus years.
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