Investment Drawdown: Definition & Calculation

Instructor: David Bartosiak

Dave draws off his years of experience as a Financial Advisor and Analyst to teach others all about finance and the investing world.

One way to measure volatility of an investment is to look at its investment drawdown. This lesson explores how to calculate an investment drawdown and defines key concepts to understand like high-water marks.

A Hidden Measure of Volatility: Investment Drawdown

Investors often look at one thing when they are evaluating an investment- historical returns. It makes sense that investors would care the most about what returns have been in the past. While we've all heard the old adage, 'Past performance is no guarantee of future results', it's still good to know the track-record of the investment you are looking to invest your hard-earned money into.

Another important factor to know about an investment is the investment drawdown. The investment drawdown measures the lowest point of an investment after its most recent high-water mark. The high-water mark is the highest value an investment has achieved. Measuring this drawdown can clue investors into just how volatile an investment's returns are.

Let's say Henry is looking to invest $10,000 and is comparing investments in Fund A versus Fund B. Fund A has had historical returns averaging 10% while Fund B has only averaged 5% per year. While Fund A has an investment drawdown of 20%, Fund B has an investment drawdown of only 5%.

That means that at one point Fund A was down 20% from its high-water mark. If Henry had the misfortune of investing in Fund A at its high-water mark, he could have seen his investment in Fund A drop from $10,000 to $8,000. If Henry had invested his $10,000 in Fund B at its high-water mark and been invested for the drop, his $10,000 would have dwindled to $9,500. Depending on the kind of investor Henry is, Fund B could be a more palatable choice.

Illustration of the hypothetical performance of an investment in Fund A versus Fund B
drawdown

More conservative investors look for investments which have smaller drawdowns, often giving up the change for larger investment return. For these investors, it's more important to not lose their money than it is to gain a large return. Conservative investors often times avoid more volatile investments. Since investment drawdown is a measure of volatility, they would avoid funds with a larger investment drawdown.

Measuring from Peak to Valley

Investment drawdown is expressed as a percentage. This gives investors a clue as to what they would experience if their accounts were fully invested during the drawdown. The maximum drawdown level is the most recent low following the high-water mark. The investment drawdown is calculated by subtracting the maximum drawdown level from the high-water mark and dividing the difference by high-water mark.

Investment drawdown % = (high-water mark - maximum drawdown level) / high-water mark

It's important to note that investment drawdown is a not a hypothetical value nor is it a future constraint. Just because a fund has historically experienced an investment drawdown of only 5% doesn't mean it can't experience a larger drawdown in the future.

After putting in a new high-water mark and a new maximum drawdown level, a new investment drawdown can be calculated. This new percentage is always compared to the previous investment drawdowns. Whichever period has the largest drawdown is the investment drawdown percentage for the investment.

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