Using drawdown as a measure of investment risk
The standard and most talked about measure of risk in finance is standard deviation. While standard deviation has its reasons for existence in academic literature, a more applicable and intuitive measure of risk would be drawdown.
The drawdown of an investment is simply defined as the largest loss that occurs in the past. That is the difference between the highest and lowest price in all the historical price movements of the asset. Measurement of drawdown needs to consider the time period. In other words, the percentage lost from the highest point to the lowest point within a period.
In equation form,
Drawdown = highest price – lowest price X 100%
lowest price
Further extending the concept of a drawdown, another parameter can be used to assist in deciding on what stocks, bonds and other financial assets to buy and when to buy.
The length of a drawdown is the time taken for the price of an investment to equal or exceed its previous peak price. Again, the time period in measuring the length of drawdown also needs to consider.
What is the significance of using drawdown and length of drawdown as opposed to standard deviation?
The answer is very important and very significant. Standard deviation does not tell you certain elements that are crucial for you as an ordinary investor. Unlike Warren Buffett and Bill Gates, most of us may not have substantial capital in the first place and income along the way to invest until we can simply live on from dividends from stocks, coupon payments from bonds and rental income from properties. That is mean to say we need to cash out the capital from those financial assets.
Secondly, asset allocations accounts for more of the results than selecting individual stocks and bonds. For example, selecting individual stocks does not determine investment performance more than selecting based on value/growth, cap size and industries. One perfect example is in two different and yet related industries in view of changes in oil price. During periods of rising oil prices, a great number of energy stocks rises while that of automobile companies fared badly. In other words, developments that occur across industries had a greater impact on its stocks than company-specific events.
As a result, drawdown and length of drawdown came in handy when invest based on some categories rather than individual stocks as behaviors of these two measures of risk are much more predicable than single stocks.
Subjecting to differences in each person’s profile and his expected holding period, there are three simple steps to compare the risks of distinct investments using drawdown.
1. Determine the “bear market”, i.e. worst period for each investment that you are considering and hence comparing.
This is making a conservative estimate using the historical worst case scenarios.
2. Calculate the historical value of the drawdown and length of drawdown for each investment during the period that it fared the worst which most probably not be the same for each class of asset.
Although past performance does not equal future results, it is still wise to know how badly the investment does in the past.
3. For each worst “bear market” period, a higher risk investment is defined by a larger historical drawdown and/or larger length of drawdown.
A high drawdown, together with high corresponding length of drawdown means that the investment is more risky and allocation of capital in the particular class of asset needs to plan and adjust accordingly. In addition, it’s annualized returns during the calculation of the drawdown period needs to be higher to justify its higher risk.
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Valuable thoughts and advices. I read your topic with great interest.
I liked it. So much useful material. I read with great interest.