What is Drawdown in Stock Market

‘Stock markets is one of the most difficult ways to make easy money’ – Anonymous. 

This saying depicts the practicality of stock market trading as it can often test investor patience despite using the best of knowledge and due diligence capabilities. We all know how the stock markets undergo constant volatility with cycles of bull phases followed by bear conditions and the same goes on in a loop.

Investors who know how to maintain their positions even during market downtimes are considered wise and often tend to survive the markets in the long run. To gain such expertise, investors must know about various market terminologies and what they mean. This allows a better understanding of market functionality and a stronger grip on equity investments.

One such terminology that new market entrants should know about is ‘Drawdown’. Let’s understand the meaning of drawdown and how it can enhance our decision-making capability in the markets.

What is a drawdown?

Drawdown is a phase in the stock markets that has the highest potential for loss in the investment value. 

Drawdown is the difference between the market’s peak and a subsequent trough within a time range. However, it should not be mistaken to be the same as a loss incurred due to purchase price and sale price differential. 

This concept tells us the extent to which a stock’s value may decline. Expressed in percentage form, it is calculated as the difference between the stock’s highest and the lowest price, or peak and trough within a certain time frame.

You can use the below image to create something similar for pictorial representation of the concept:

Image source –  WallStreetMojo  

Understanding drawdown with an example

Here is an example to better understand how drawdown can be used as a stock market investment strategy. 

Most stock market traders or investors keep churning their capital by entering or exiting a stock from time to time. If suppose, an investor invested Rs. 10 lakhs in the markets and earned Rs. 5 lakhs on this investment within a year, the returns are about 50%.

At such a time, the market undergoes correction or falls. This brings down the investor’s portfolio value to Rs. 13 lakhs from the earlier Rs. 15 lakhs.

As per the investor’s calculations, the portfolio has still earned positive returns of 30%. 

If we look at this from the drawdown perspective, we need to consider the highest value of the investment, which was Rs. 15 lakhs and deduct the lowest value of the investment or Rs. 13 lakhs. This shows us a net drop of 13%.

How drawdown can be used in risk assessment?

By analysing drawdown, traders and investors can enhance their strategy through a more accurate risk assessment of their investments. This way, one can minimize losses and aim for higher profitability of the investment. 

So what does a drawdown indicate about investment risk?

1. A low drawdown value means lower risk and stable investment.
2. Investors willing to take on higher risk against higher returns can go for stocks with higher drawdown.

Drawdown should also be considered from an investment timeline perspective since it tells investors how much time it may take to recover the original investment value with the given drawdown. 

Benefits of drawdown

Some of the ways that investors/traders can use drawdown to their advantage are:

1. Looking at historical drawdowns of investments, investors and traders can understand the pattern of likely troughs and peaks. This helps in the easy identification of exit opportunities at higher profits. Similarly, investors can know about the right time to enter the markets.
2. By calculating the drawdown on a stock, a trader/investor can know its risk-to-return ratio. If the stock may carry higher risks, a higher drawdown ratio is preferable and vice versa.
3. Investors can also use the drawdown of various stocks to appropriately diversify their portfolios.

Factors to consider while using drawdown in investment strategies

Since drawdown provides a relative measure rather than an absolute loss, it is indicative of a temporary decline in the investment value. Therefore, long-term investors may take incorrect decisions if they fear the severity of short-term losses as reflected by drawdown.

Traders and investors who are new to the markets may not be able to fully comprehend this concept, and end up taking wrong decisions instead of enhancing decisions.

Conclusion

Drawdown is one of the factors that help investors interpret market turbulence for better investment decisions. Investors can use drawdown to trade or invest below the trough while exiting around the peak. This can minimise losses during volatile markets and enhance profits during peaks.

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