The Role of Drawdown in Banking and Trading

Key Takeaways

• A drawdown is the percentage of decline over a period in the value of an investment, fund, or trading account before it reverts to its original value or more.

• Drawdowns can be used to assess historical trading data and to identify red flags that the falling values demonstrate.

• While drawdowns do offer the benefits of risk assessment, there is investor risk when factoring in the share price increase required to surmount a drawdown.

Understanding the concept of “drawdown” is integral to trading and banking strategies. As such, this article covers the ins and outs of drawdowns as they relate to stocks, loans, and retirement, and how the term differs in banking and trading.

What is a Drawdown?

A drawdown is the percentage of decline over a period in the value of an investment, fund, or trading account before it reverts to its original value or more.

Drawdown is expressed as the difference between the asset’s peak and trough value, and helps investors identify a particular investment’s risks so that they can efficiently employ asset management. In other words, drawdown offers best and worst-case scenarios.

Generally, the steeper the drawdown, the more difficult it is for an investment, fund, or trading account to spring back to normal levels.

For example, given market volatility, a 20% drop in an investment’s value is normal. However, there will be cause for concern if that percentage doubles or more. As the chasm widens, it becomes harder for that investment to return to its original value.

Drawdowns can be used to assess historical trading data and to identify red flags that the falling values demonstrate. Also, they allow investors to follow and compare funds’ and other trading instruments’ performance.

For example, say a person invested $10,000 at the start of 2019, and within a week, one of the stocks underperformed, dropping its value to $9,000. Early the following year, one of the stocks became obsolete, causing a sudden steep decline of $6,000 in the portfolio’s value.

Around six months later, a stock’s performance caused the portfolio’s value to rise to $11,000, absorbing losses incurred from the obsolete stock. Here, the portfolio’s drawdown is the drop in value before the portfolio got back to $11,000. Therefore, the drawdown is $4,000 ($10,000 minus $6,000), or 40%.

In another example, say a trading account contains $10,000, and the fund’s value decreases to $9,000 before returning to more than $10,000. In that case, the account experienced a 10% drawdown.

Note that “drawdown” takes on different meanings in other sectors, such as in mortgage and banking.

Understanding Drawdowns

In drawdowns, a tool called the Ulcer Index is employed to track an account’s decline and recovery and is effective for as long as the price is under the peak. In the last example above, the drawdown comes to 10% until the account gets back above $10,000. Once that occurs, the drawdown is recorded.

With this approach, a trough may not be measured until there is a new peak. As long as the value or price lingers under the old peak, a lower trough could happen, which would raise the drawdown percentage.

There are multiple kinds of drawdowns, including:

— Stock. The change from a stock share’s peak price to its trough is commonly viewed as the stock’s drawdown amount. For example, if a stock’s price decreases from $100 to $50, then bounces back to at least $100.01, the drawdown was $50 or 50% of the peak.

— Loan. This kind of drawdown refers to a lender’s disbursement of funds to a borrower. The date on which the lender disburses funds is known as the drawdown date. For example, a mortgage or home loan is a drawdown loan used to buy property.

— Retirement. Here, a drawdown is income received during retirement. The portion of income retirees withdraw from their retirement savings to keep up a certain standard of living is called a drawdown percentage.

Drawdown in Banking vs. Trading

When it comes to banking and trading, “drawdown” has different applications.

• Banking. In banking, drawdown refers to the gradual access of credit funds — part or all of a credit line. For example, a homeowner asks their bank for a line of credit for major home renovations. Since he will not do all the work at once, it behooves him to only draw down funds as needed. That way, he can keep debt and interest payments down.
• Trading. In trading, the term means a reduction in account equity. Here, it is considered more accurate to view a drawdown as from a peak high to a trough to a new peak high. The idea is that, until either a new peak is reached or there is a return to the original high, troughs cannot be positively identified.

Risk of Drawdowns

While drawdowns do offer the benefits of risk assessment, there is investor risk when factoring in the share price increase required to surmount a drawdown.

For example, to reach the first peak, a 20% drawdown calls for a 25% return. Recovery from a 50% drawdown necessitates a 100% hike.

There are investors who opt to forego drawdowns of more than 20% before turning their position into cash.

There are other considerations and limitations, including:

• The percentage can vary among stocks, trading accounts, and funds.
• Results can be misleading, as a lower value can be due to unfavorable news reports. Here, the dropping prices are merely temporary.
• The drawdown may be difficult to determine if random variation exists in the stocks.
• The stock may be manipulated by traders to mislead the market by faking the fund’s positive performance.

How to Assess Drawdowns

Typically, having a diversified investment portfolio, and knowing the length of the drawdown’s recovery window, can reduce risk. Many financial advisors recommend individuals who have recently retired or who have more than a decade until retirement limit their drawdown to 20%, which should be enough to shelter the holdings for a recovery. 

From stocks to mutual funds, many retirees keep an eye on their investment’s drawdowns so that they can try to eschew those with the largest drawdowns historically.

How to Recover from a Drawdown

The time it takes to recover a drawdown is a factor in establishing risk, since how investments act can differ. Some investments recover more quickly than others, while others may take years to recoup. Thus, drawdowns should also be viewed in light of the time it has typically taken an investment to recover the loss.

Alternatives to the Stock Market

Alternative investments, such as those offered by the leading investment platform Willow Wealth, comprise asset classes such as real estate and private equity.

Since they are in the private market, alternative investments — basically any asset classes other than stocks and bonds — are increasingly popular as refuge from inherently volatile public markets. After all, private markets have performed better than stocks in every economic downturn of the last 15 years-plus.

So, while diversification is key to lowering drawdown risk, it is also essential in reducing overall investment portfolio risk, particularly when used in conjunction with alternative investments.

Private Markets and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, platforms like Willow Wealth provide curated access to private markets for individual investors.   

Investors can get started with minimum investments as low as $5,000 for their first investment (subject to certain exceptions). Willow Wealth offers a curated selection of opportunities across multiple asset classes, ranging from individual investments to diversified funds and automated portfolio solutions. While these investments carry risk, they open the door to opportunities across real estate, private credit, private equity, and more.  

Join more than 500,000 members and start investing in private markets today at willowwealth.com. 

Summary

In trading, drawdowns can be employed to gauge risk, but they carry risk of their own involving the share price increase required to overcome them.

Still, when potential risks are identified, investors can make better investment decisions. Remember, too, that drawdowns are generally unnecessary in private-market investing in alternative assets.