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Learning about drawdown

Overview

Published: 02/22/2013

by Warren Mackenzie

Drawdown, in a nutshell, gives the history of how much a particular investment has dropped in value before it recovered.
If you know the drawdown of an investment (or your portfolio as a whole), you know what to expect in terms of potential future losses.

The problem is that unless we specifically ask for this information, or we look it up ourselves, we are unlikely to know
our performance compared to a benchmark – let alone our portfolio’s drawdown.

 

Average returns over a three- or five-year period tell you nothing about the potential loss that is hidden within the
‘average’ rate of return.

 

An investment that averaged 8% over five years might have dropped in value by 50% over a period of a few months.

 

If you see the annual return earned each calendar year, you will have a better idea of the risk – but even annual
returns don’t show the amount an investor could have lost if they bought and sold at the wrong time during the year.

 

As a drawdown example, consider BMO Canadian Equity Class (a Canadian equity mutual fund). The annual return since
inception (Oct. 2004) is 4.4%. Given today’s investing environment, this might seem to be an OK return. However, with more information, we can see two problems.

 

First, the benchmark index return for the same period was 9.1%, so the fund actually underperformed by about 5% per
annum. The second point is that the annual return tells us nothing about the volatility of the fund – and it is worse than you might expect. If you check Google Finance, you will see that the unit value dropped from $16.68 on May 16,
2008, to $9.25 on March 6, 2009. This is a 44% drop in value and could come as quite a shock to a person who thinks that an average return of 4.4% means average risk as well.

A drawdown is measured from a peak – from the time the security stops going up to the bottom of the trough. One problem
is that we don’t know for sure where the bottom is until the market has fully recovered and has hit a new high.

 

After a new high has been hit, we can measure from the previous peak to the trough and this is the drawdown. This is
the percentage loss that those investors who bought at the peak were facing at the trough.

 

In the above example, the fund has not yet recovered its losses and has not reached a new high, so by definition we cannot
say if the drawdown is complete – or if the final number will be worse than 44%.

 

Drawdown can be measured for an individual security and also for a portfolio as a whole. No one can predict the future,
but a financial advisor should be able to give you the history of the worst drawdown for a portfolio with an asset mix similar to yours.

Remember, wise investors know the risk they are exposed to and they take no more risk than necessary to achieve their
financial goals.  

 

Warren MacKenzie, CA, CFP, CIMA, is president of Weigh House Investor Services of Toronto. He can be reached at
warren.mackenzie@weighhouse.com or 416-640-0550.

 

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