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What is drawdown? Its crucial relationship to performance and risk

What is Drawdown?

In investing, certain terms are frequently used. “Drawdown” is one such term, describing the decline in an investment’s value from its peak to a subsequent low, as well as the time it takes to recover.

For instance, during the dot-com bubble, the NASDAQ peaked in March 2000 and plummeted by nearly 78% by October 2002. It took until April 2015, a span of nearly 15 years, for it to fully recover to its previous high.

In a similar vein, the ASX200/XJO reached its zenith in November 2007 and faced a drawdown of approximately 54% by March 2009 during the global financial crisis. The ASX200/XJO took around 11 years to surpass its 2007 high, marking its full recovery in early 2019.

Key Perspectives on Drawdown Evaluation

All market investments experience drawdown. When looking at drawdowns, it’s important to think about it in two main ways:

  1. Personal Tolerance: Investors and traders need to look inward and assess how much of a drop in value and how long of a downturn they can personally handle based on their goals, finances, and attitude toward risk. Everyone has different limits here, so knowing your own is key.
  2. Investment Outlook: Sometimes a drawdown can point to deeper changes in how well the investment will perform long-term. So it’s crucial to determine whether the drawdown is just temporary or a sign of bigger issues.
Types of Drawdown

Not all drawdowns are the same. They happen in different forms based on different factors. To really understand them, it helps to know the main types – floating loss, profit, and equity drawdowns.

Floating Loss Drawdown

This is when the market value of an investment goes down but the investor decides to hold onto it. The loss just “floats” there until the investment is actually sold.

Profit vs. Equity Drawdown

A profit drawdown is a drop in the profits earned from an investment. An equity drawdown is a drop in the total value of an investor’s whole portfolio. Both are important in shaping strategy.

Length of Drawdown

All investments have drawdowns, but the length matters a lot. After big market crashes, stock investments can often stay down for years. Beyond just losses, long drawdowns tie up money that could have been used elsewhere.

Drawdown illustrated

Managing Drawdowns

Having a plan to handle drawdowns is crucial for investing wisely. Diversifying investments, setting risk limits, and keeping a close watch on the market can all help minimise their impact.

Risk vs. Reward: Making Informed Choices

Investing is always a balance between risk and reward. It’s tempting to focus solely on the potential gains, but it’s equally important to understand the risks involved. The relationship between risk and reward helps investors make decisions that match their comfort level and financial goals.

Every investment carries some level of risk. Typically, higher potential returns come with higher risks. So, while an investment might promise big returns, it could also lead to significant losses. It’s essential to weigh these potential outcomes before making a decision. Just chasing high returns without considering the risks can lead to unexpected setbacks. On the other hand, being too cautious could mean missing out on valuable growth opportunities.

For a well-rounded investment strategy, consider both the potential return and the associated risk. Look at the history of an investment: has it had big ups and downs or has it been more stable? Understanding the balance between risk and reward will help guide smarter, more informed investment choices.

In Summary

Drawdowns are a key part of investing. The different types like floating, profit, and equity drawdowns all impact investors differently. And things like high-water marks and risk vs. reward add further complexity. Understanding drawdowns and having a plan to handle them helps investors navigate the ups and downs of the market wisely.

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      “It is essential to wait for trades with a good risk/reward ratio. Patience is a virtue for a trader.” – Alexander Elder

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