Drawdown: What exactly is it?
At a glance
• Drawdown is the term used to describe the maximum loss on an investment between a peak and the subsequent trough, expressed as a percentage.
• It is one of the most useful indicators for evaluating the actual risk and volatility of financial instruments, including shares, funds, ETFs, and indices.
• The greater the drawdown, the greater the gain required to recover: a 50% fall requires a 100% rise.
• With Carregosa NextGen, you can invest with a strategic vision and discipline thanks to access to funds, ETFs, and shares.
Can you imagine investing for months, watching your portfolio reach a high … only to see it fall by 20%, 30%, or even more? The term for this decline is "drawdown”.
It measures the depth of losses over time, which can change how you perceive risk, volatility, and strategy. If you want to make more informed investments, it’s important to understand this indicator.
What does "drawdown” mean?
In simple terms, drawdown is a financial indicator that measures the percentage decrease in an investment’s value from its highest point (peak) to its lowest point (trough) before it recovers.
In other words, it measures the total loss between two points: the peak and the subsequent trough before the next recovery. The focus is always on the amount lost from the highest point reached. Drawdown does not consider the initial amount you started investing with; rather, it looks at how far you have ‘fallen back’ since reaching your peak. This metric helps you to understand the worst-case loss scenario before recovery.
This concept is primarily used to analyse investment funds, ETFs, and stock market indices.
How is drawdown calculated? (a step-by-step example)
Drawdown (%) = ((Peak value - Trough value) / Peak value) × 100
Imagine you’ve invested €10,000. Its value rises to €12,000 (peak), then falls to €9,000, before rising again. The drawdown is calculated from the peak value:
((12,000 - 9,000) / 12,000) × 100 = 25%
Note: the drawdown is 25%, despite the fact that you started with €10,000. It is always calculated from the highest point reached, since this is the reference point for the "worst decline”. This calculation applies to all three: funds, ETFs, and indices.
Drawdown vs. maximum drawdown: what’s the difference?
Drawdown refers to a fall that occurs between a peak and the next trough before recovery. There may be several drawdowns of varying magnitudes over time. The maximum drawdown (MDD) is the largest of these falls over a given period, representing the worst-case historical scenario for cumulative loss.
| Concept | Definition | Example |
|---|---|---|
| Drawdown | Any fall from the peak to the next trough | Drawdowns of -8%, -15% and -22% |
| Maximum drawdown (MDD) | The largest of these falls over the period analysed | -22% (the deepest trough) |
The maths behind recovery: why deep drawdowns "hurt” more
"Drawdowns cannot be avoided – they must be managed. The ability to predict in advance how much a portfolio might fall is what distinguishes a disciplined investor from a panicked one.” — João Queiroz, Head of Trading at Banco Carregosa.
Many investors overlook one key detail: recovering from a fall always requires a proportionally larger rise. Losing 50% means that gaining 50% is not enough to get back to where you started; you need to gain 100%. The greater the drawdown, the harder (and longer) it takes to recover.
| Fall (drawdown) | Gain required to recover |
|---|---|
| -10% | +11.1% |
| -20% | +25% |
| -25% | +33.3% |
| -30% | +42.9% |
| -50% | +100% |
This is why limiting the depth of falls is just as important as seeking returns: avoiding severe drawdowns can save you years of recovery time.
How long does it take to recover from a drawdown?
Depth alone doesn’t tell the whole story. The time taken to recover can also vary greatly, even between drawdowns of similar magnitude. This is illustrated well by two real-world examples from the S&P 500:
• COVID-19 (2020): it fell by around 34% between February and March; recovered in around 6 months.
• Financial crisis (2008): it fell by around 57% between October 2007 and March 2009; it took around 5 years for it to recover its previous value.
The upshot is that a deeper drawdown will usually take much longer to recover from, which is a decisive factor if you have a short investment horizon.
What is an acceptable drawdown?
There is no one-size-fits-all number: the "right” level of drawdown depends on your objectives and time horizon, but most importantly, your ability to withstand losses without having to sell at the worst possible moment.
It is more important to be consistent with your strategy than to focus on the figure itself. In practice, if a drawdown causes you to abandon your plan, it is too high for you.
The benefits of analysing drawdown
Assessing the real risk of an investment
Average returns don’t tell the whole story. For example, two investments may have the same annual return, but very different drawdowns. A fund that has fallen by 50% requires much greater emotional resilience than one that has suffered a maximum loss of 15% over time.
Testing your emotional tolerance for risk
Understanding that an investment could fall by 30% helps you to assess whether you would be able to maintain your strategy in the event of a crisis. Many investors sell at the worst possible moment because they are not prepared for the drawdown.
Improving risk management
Understanding historical drawdowns enables you to adjust your asset allocation, set loss limits – for instance, by placing a stop-loss or stop-limit order – and rebalance your portfolio. In other words, it converts volatility into strategic information.
The limitations of drawdown
Although it is useful, drawdown should not be analysed in isolation. The following are its main limitations:
It assesses past data
Drawdown is based on historical data. For example, an asset that has previously experienced a maximum drawdown of 20% could face a drawdown of up to 40% in a future crisis.
It does not measure the speed of the fall
Although a 25% fall over two days is different to a 25% fall over two years, the percentage drawdown may be the same. The indicator does not fully reflect the time dimension of risk.
It does not take recovery time into account
While two investments may have the same maximum drawdown, one may recover in six months while the other takes five years, as we saw above. Although recovery time is crucial, it is not reflected in the drawdown figure.
It may affect assets that are more volatile, but also more profitable
Growth assets, such as technology shares, tend to experience larger drawdowns, but also offer greater potential for appreciation. Focusing solely on the depth of the fall can lead to overly cautious decisions.
Other risk indicators to combine with drawdown
Although drawdown is a good place to start, to truly grasp the concept of risk, it must be examined from various angles. More experienced investors use a combination of indicators:
• Volatility (standard deviation): this measures the variation in returns over time, i.e. the frequency and intensity of day-to-day fluctuations.
• Sharpe ratio (see article): this ratio assesses the additional return generated for each unit of risk (volatility) taken on.
• Sortino ratio: similar to the Sharpe ratio but only considers negative volatility (downsides).
• Value at Risk (VaR): it estimates the maximum expected loss over a given period with a given level of statistical confidence. It looks to the future, not the past.
• Calmar ratio: the balance between growth and the depth of declines is shown by the average annual return relative to the maximum drawdown.
• Beta: it measures an asset’s sensitivity to the market. A beta greater than 1 amplifies market movements and drawdowns.
Drawdown: invest with experts at Carregosa NextGen
Understanding what drawdown is can help you to invest with greater financial maturity. It’s not just about seeking returns; it’s also about understanding and preparing for potential declines.
At Carregosa NextGen, you can access investment funds, ETFs, and shares via the GoBulling Investor platform. You can also access market analysis to help you assess the risks, returns, and consistency of your investment strategies. After all, investing is about managing losses wisely, not avoiding them.
Contact us to learn how to invest strategically and build a portfolio tailored to your profile.
Drawdown: FAQs
Is high drawdown always bad?
Not necessarily. While a high drawdown can indicate greater volatility, it can also be associated with higher potential returns. You should analyse it in the context of your strategy and risk profile.
What is considered an acceptable drawdown?
It depends on the investor’s profile. Those with a conservative profile tend to accept smaller declines (e.g. 10-15%), whereas those with an aggressive profile may tolerate fluctuations of over 30%.
Are drawdown and volatility the same thing?
No, volatility measures frequent price fluctuations; drawdown measures the largest cumulative fall from a peak to a trough.
How is maximum drawdown calculated?
Identify the highest peak and the lowest trough following it within the given time period and apply the following formula: ((peak - trough) / peak) × 100. The maximum drawdown is the highest value recorded during the period.
How long does it take to recover from a drawdown?
It depends on the severity of the fall and the asset in question. Mild declines tend to recover within months, whereas sharp declines can take years. For example, the S&P 500 recovered from the ~34% slump caused by COVID in around 6 months. However, it took around four years to recover from the ~57% slump caused by the 2008 crisis, with the index returning to its highs in early 2013 after reaching its low in March 2009.
What was the biggest drawdown in the S&P 500?
One of the most severe falls in recent decades occurred during the 2008 financial crisis, with the market dropping by around 57% between October 2007 and March 2009.
What is the difference between drawdown and Value at Risk (VaR)?
Drawdown measures past losses, i.e. the largest fall ever recorded. VaR, on the other hand, estimates the maximum expected loss in the future with a given statistical confidence level.
Does drawdown apply to funds and ETFs?
Yes, it is one of the most widely used indicators for evaluating the historical risk associated with investment funds, ETFs, and stock market indices.
Legal Disclaimer: This article has been prepared by Banco Carregosa for informational and educational purposes only. Under no circumstances does it constitute an investment proposal, recommendation to purchase, or personalised financial advice. Investing in financial instruments carries risks, including the possibility of losing the capital invested. Past performance does not guarantee future returns. We recommend that you consult an account manager or financial adviser before making any investment decisions, to ensure that they are suited to your risk profile and financial objectives.