Drawdown

Business / By / September 6, 2023

Drawdown, a key investment metric, gauges the peak-to-trough decline in an asset’s value. Calculated by subtracting the lowest point from the highest during a defined period, it offers insights into risk and portfolio management. Investors rely on drawdown to assess historical losses and employ diversification to mitigate its impact.

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  • Definition: Drawdown refers to the measure of a financial asset’s decline in value from its highest point (peak) to its lowest point (trough) during a specific period.
  • Risk Assessment: It serves as a crucial tool for assessing and quantifying the risk associated with an investment or portfolio. Higher drawdowns typically indicate greater risk.
  • Calculation: The calculation of drawdown involves identifying the peak value (the highest point the asset reaches) and the trough value (the lowest point) during the chosen time frame.
  • Drawdown Percentage: To calculate the drawdown percentage, use the formula: (Peak Value – Trough Value) / Peak Value. This formula expresses the drawdown as a percentage of the peak value.
  • Investment Evaluation: Drawdown helps investors evaluate the historical risk of an investment. It provides insights into how much an asset has lost during market fluctuations.
  • Volatility Indicator: Drawdown is a significant indicator of asset or portfolio volatility. Investments with frequent and severe drawdowns are considered riskier.
  • Risk Management: It plays a pivotal role in risk management strategies. Investors and fund managers use drawdown analysis to make informed decisions about asset allocation and risk tolerance.
  • Portfolio Diversification: Diversifying a portfolio across various asset classes, such as stocks, bonds, and real estate, can help mitigate the impact of drawdowns on overall performance.
  • Duration Variation: Drawdowns can vary in duration, from short-term corrections to prolonged bear markets. Understanding the duration of a drawdown is essential for investment planning.
  • Investor Psychology: Drawdowns can challenge investor psychology as they often coincide with emotional reactions. Staying disciplined during drawdowns is crucial for long-term investment success.
  • Examples: Drawdowns occur in various financial contexts, including stock markets during market corrections and crashes. Hedge funds report drawdown figures to inform investors about potential risks.
  • Performance Analysis: Drawdown analysis is often used alongside other performance metrics like the Sharpe ratio and Sortino ratio to provide a more comprehensive view of an investment’s risk-return profile.
  • Recovery Period: After a drawdown, it takes time for an investment to recover to its previous peak. Understanding the recovery period is vital for setting realistic investment goals.
  • Drawdown Tolerance: Investors should determine their drawdown tolerance based on their financial goals, risk appetite, and time horizon. This tolerance level guides their investment decisions.
  • Risk Mitigation Strategies: In addition to diversification, investors may employ risk mitigation strategies such as stop-loss orders and asset rebalancing to minimize drawdown-related losses.
  • Historical Analysis: Examining historical drawdowns of specific investments or asset classes can provide insights into how they perform under different market conditions.

Key Highlights of “Drawdown”:

  • Definition: Drawdown measures the decline in an asset’s value from its highest point to its lowest point during a specific period.
  • Risk Assessment: It’s a critical tool for assessing investment risk, helping investors understand potential losses.
  • Calculation: Drawdown is calculated using the formula (Peak Value – Trough Value) / Peak Value.
  • Volatility Indicator: It indicates asset or portfolio volatility, with higher drawdowns signaling greater risk.
  • Risk Management: Drawdown analysis guides risk management decisions, including asset allocation.
  • Portfolio Diversification: Diversifying across asset classes helps mitigate drawdown impact.
  • Investor Psychology: Drawdowns can challenge investor emotions, requiring discipline.
  • Examples: Seen in stock market corrections and hedge fund reporting.
  • Performance Analysis: Combined with other metrics, it offers a comprehensive risk-return view.
  • Recovery Period: Understanding the time it takes for an asset to recover from a drawdown is crucial.
  • Drawdown Tolerance: Investors set tolerance levels based on goals and risk appetite.
  • Risk Mitigation: Strategies like stop-loss orders and rebalancing help minimize drawdown-related losses.

Connected Financial Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

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Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

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The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

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Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

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Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

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Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

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Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

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Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

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Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

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Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

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Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

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Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

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Income Statement

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The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

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The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

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The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

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Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

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Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

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Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

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Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

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WACC

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Financial Option

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A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Profitability Framework

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Triple Bottom Line

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The Triple Bottom Line (TBL) is a theory that seeks to gauge the level of corporate social responsibility in business. Instead of a single bottom line associated with profit, the TBL theory argues that there should be two more: people, and the planet. By balancing people, planet, and profit, it’s possible to build a more sustainable business model and a circular firm.

Behavioral Finance

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Behavioral finance or economics focuses on understanding how individuals make decisions and how those decisions are affected by psychological factors, such as biases, and how those can affect the collective. Behavioral finance is an expansion of classic finance and economics that assumed that people always rational choices based on optimizing their outcome, void of context.

Connected Video Lectures

Read Next: Biases, Bounded Rationality, Mandela Effect, Dunning-Kruger

Read Next: Heuristics, Biases.

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About The Author

Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
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