Table of contents
Volatility is one of the most suitable words to describe the stock market. While this is a major attraction for some investors, others stay away from the stock market for the same reason. Due to its volatile nature, the stock market has the potential to help traders earn exponential profits, but equally high losses are probable, too.
Hence, analysing various aspects before investing and reviewing the performance of investments is crucial to make appropriate decisions. One such factor that helps analyse the performance of investments is drawdown. In today’s article, let us learn the meaning of drawdown in finance and its significance.
What is a drawdown?
Drawdown is a term used to measure the amount of reduction in an investment’s value. It is often used by traders and investors to analyse the dip in the value of their investment portfolios.
Understanding drawdown in trading
Market risk is one of the primary risks associated with investments, especially in the stock market. It is where the market price of investments fluctuates due to market events. In the case of stock markets, stock prices fluctuate as they react to various economic policies, management decisions, the company’s financials, etc. With each fluctuation, owners of the stock face ups and downs in their investment value. That is where the concept of drawdown comes in.
Drawdown is usually the difference between the highest and lowest market value of the investment. When the investment value falls after reaching a peak, it indicates a drawdown, suggesting the underperformance of securities in the portfolio. The reasons and value of the drawdown help investors analyse what went wrong so that they can take corrective actions to recover the value lost.
Calculating drawdown
Drawdown can be calculated both in terms of value and percentage.
Drawdown value: The highest value of the investment – The subsequent low value of the investment
Drawdown percentage: [(The highest value of the investment – The subsequent low value of the investment) / The highest value of the investment] * 100
Example
Let’s take a hypothetical example of Company ABC, trading at ₹150 in the stock market. Trader A buys 100 shares of ABC at ₹150, making the total investment value ₹15,000 (₹150 * 100 shares).
Company ABC announces its annual results. The results show that the firm’s performance has been impressive and better than in previous years. This positively impacts the stock price as more investors buy the stocks of ABC. The stock price has now reached ₹200, making Trader A’s total investment value ₹20,000 (₹200 * 100 shares).
One month later, a fraudulent activity at ABC for spiking up their annual numbers is exposed. It significantly affects the firm’s goodwill, and the stock price falls to ₹165. Now, Trader A’s total investment value is ₹16,500.
So, the investment is trading at a drawdown of ₹3,500 (₹20,000 – ₹16,500), which is the difference between the investment’s highest and lowest value. The drawdown percentage is 17.5% (3,500/20,000 * 100).
The essence of analysing drawdowns
Analysing drawdowns is a significant part of investing. While studying stocks and the market before investing is vital, reviewing whether the investment is yielding results as expected is equally essential.
- Drawdowns help traders understand how their investments have performed during a specific period. It helps them assess whether their investments have been able to withstand downturns in the market. This is a crucial factor in forming investment strategies.
- It also helps traders understand whether their previous strategies have been able to mitigate risks. Otherwise, drawdown acts as a trigger to take corrective actions.
- Drawdowns play a significant role in helping traders prepare for losses and set realistic expectations.
Bottomline
Drawdown is a concept in the investment world that helps investors measure the reduction in the value of their investments. It is the delta between the investment’s highest high and the subsequent low.
Understanding drawdowns is crucial for traders to analyse the effect of their investments and take corrective actions when necessary. So, the next time you invest in a financial instrument, do not miss to check the drawdown while reviewing your investments. Happy investing!
FAQs
A drawdown of 5% suggests that the investment value has been reduced by 5%. It suggests that the investment has gone 5% below its previous high.
The drawdown is an indication that the stock is negatively reacting to market events. It is a trigger for investors to revisit their investments and strategies.
Avoiding drawdowns entirely may not be possible. Every stock is prone to fluctuations in both directions. A stock’s price will start falling after reaching a peak. Hence, eliminating drawdowns may not be possible.
However, to reduce the impact of drawdowns, analysing the stocks and investing in those with strong fundamentals is essential. Also, diversification is an important strategy to handle drawdowns.
Drawdown and loss are two different concepts. A loss is negative while a drawdown may or may not be negative.
A loss occurs when the selling price is lower than the purchase price. A drawdown, on the other hand, happens when the investment value falls after reaching a high. This does not necessarily mean that the value has fallen below the purchase price.
A real-world example is drawdowns in the values of indices like SENSEX.
Analysts have observed that the value of SENSEX faces a drawdown of about 25%, once every 3.5 to 4 years. Such a drawdown was noted during the COVID-19 pandemic, and analysts expect such occurrences again in the future.
There is no particular number or level that determines a good drawdown. Ideally, no investor would want to face drawdowns in their investments. However, as we discussed, eliminating it entirely is not possible.
Usually, drawdowns within 20-25% is considered normal. Anything beyond that must be considered a serious signal for revisiting investment strategies.
Leave a Comment