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Discover what a drawdown is to learn how declines from a portfolio’s peak help measure investment risk and recovery time.
Drawdown is one of the most important risk indicators used in trading and investing. It tells you how much an investment has fallen from its peak before recovering. Whether you trade equities, mutual funds, crypto, or manage a portfolio using technical or quantitative models, understanding drawdowns helps you evaluate risk, measure strategy performance, and determine whether a downturn is within acceptable limits.
A drawdown refers to the decline in the value of an investment or portfolio from its highest point (peak) to its lowest point (trough) over a specific period. It is expressed as a percentage and highlights the amount of capital lost during a downturn.
Drawdowns help answer questions such as:
How much loss can your portfolio experience in a worst-case scenario
How volatile is your trading strategy
Is the current decline an ordinary fluctuation or a major risk signal
A smaller drawdown reflects a lower magnitude of decline, while deeper drawdowns show a larger reduction from the peak.
Drawdowns can be classified into different types based on duration and measurement approach:
The difference between your initial investment and the lowest equity value seen after that point. This is important for evaluating risk relative to starting capital.
The biggest peak-to-trough drop observed during a specific period. MDD is widely used in backtesting, portfolio analysis, and quant models.
The percentage decline from the highest portfolio value. It helps compare risk across different strategies or asset classes.
The length of time an investment takes to recover from a downturn. A strategy with long drawdown periods may look profitable but can be psychologically stressful and operationally risky.
The standard formula for calculating drawdown is:
Drawdown = (Peak Value – Trough Value) / Peak Value × 100
Where:
Peak Value = highest value reached
Trough Value = lowest value after the peak
Identify the highest value your investment or portfolio achieved.
Identify the lowest value reached after the peak.
Apply the drawdown formula.
Maximum Drawdown = Largest observed drawdown over the analysis period.
Consider the following examples:
Peak portfolio value: ₹10,00,000
Trough value after decline: ₹7,00,000
Drawdown = (10,00,000 – 7,00,000) / 10,00,000 × 100 = 30%
This means the portfolio fell 30% from its peak.
Trading account reaches ₹5,00,000
Losses reduce balance to ₹4,25,000
Drawdown = (5,00,000 – 4,25,000) / 5,00,000 × 100
Drawdown = 15%
A 15% drawdown indicates moderate risk exposure.
If the portfolio experiences:
First fall: 10%
Later fall: 25%
Final fall: 18%
The maximum drawdown would be 25%, the largest peak-to-trough drop.
Understanding drawdowns is important for traders and investors because:
Volatility shows price fluctuations but not actual losses. Drawdowns reflect actual capital reduction.
Traders use drawdown data to define acceptable risk levels and size positions accordingly.
A strategy with high returns but deep drawdowns is riskier than one with moderate returns and small drawdowns.
Deep drawdowns are emotionally taxing and may lead traders to exit positions prematurely.
Higher drawdowns require disproportionate returns to recover.
Example: A 50% drawdown requires a 100% gain to break even.
Drawdown analysis helps reveal how much risk a portfolio carries during market fluctuations. It highlights the depth and duration of losses, offering a clearer understanding of downside exposure than return-based metrics alone. Regularly reviewing drawdowns supports decision-making, improves resilience, and keeps risk aligned with investment goals.
Key Points to Note:
Drawdown tracks the fall from a portfolio’s peak to its lowest point.
Maximum drawdown is essential for assessing long-term risk and strategy durability.
Understanding drawdowns illustrate potential portfolio value changes.
Smaller drawdowns reflect efficient risk control and stability.
Monitoring drawdowns is vital for traders and portfolio managers alike.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
Drawdown refers to the decline in a portfolio’s value from its highest point to the subsequent lowest point before any recovery begins. It reflects the depth of a temporary setback.
Drawdown is calculated by comparing the portfolio’s peak value with the lowest value recorded after that peak, using the drawdown formula to express the decline as a percentage or absolute amount.
Maximum drawdown represents the largest peak-to-trough decline observed over a specified period. It highlights the worst historical drop an investment has experienced.
Drawdown duration measures how long it takes for an investment to rebound from its trough to the previous peak. It is a key indicator of strategy resilience and influences investor confidence.
Drawdown is not the same as a realised loss. It describes a temporary fall in value, whereas a loss is confirmed only when the investor exits or closes the position during the downturn.
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