A popular measure that is used for measuring the riskiness of an investment such as a portfolio of shares is the Maximum drawdown. If you ask a financial expert what they mean by maximum drawdown; They might give you a textbook definition that “this is the highest percentage peak-to-trough decline that an investment has experienced in a specified period”. This doesn’t really aid in helping one to understand the concept.
I will explain this concept with the following diagram below.
The red line in the diagram shows the points at which a drawdown is experienced. The formula for drawdown = (Trough-Peak)/Peak.
The purpose of drawdown is to measure a worst-case scenario. One should also monitor the length of the period the maximum drawdown occurred. In the diagram above, the maximum drawdown occurred from year 8 to year 11. So, it took 3 years for the value of the investment to fall by 56.25%. The worst-case scenario is if history repeats itself and the value of an investment falls by 56.25% in 3 years. This is useful information when investing in a fund as one may know the potential amount they may lose in a given period if things go wrong. Also, one should take the time to find out the reason why the drawdown occurred. Maximum drawdowns usually occur when something unexpected happens, so one should always ask if that same event occurred will the fund they invested in react the same way.
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