Although this concept is relatively straightforward, it has seldom been addressed in a technical sense because, for all practical purposes, it basically represents the negative half of standard deviation. SD measures a fund or investment’s total volatility, while drawdown risk only takes into account the drops in price over time in order to compute downside risk.
Be sure to also read the 7 Questions to Ask When Buying a Mutual Fund.
Why Drawdown Risk Matters
But this kind of loss can be devastating for someone who is about to retire, and so this type of risk needs to be carefully assessed in order to gauge its potential impact in an investment portfolio. If you are going to retire next year and 25 percent of your savings are held in an aggressive growth fund that has done very well over the past several years, then that fund may well be due for a substantial retracement. If that happens, will you be able to maintain your projected lifestyle in retirement without having to work for a while longer?
While other technical indicators, such as standard deviation, beta, alpha and r-squared serve as analytical tools that can be used to mathematically quantify and categorize certain characteristics of an investment, drawdown risk is a much more “real” measure of the potential impact that a substantial loss may have on your portfolio-and your life. This risk measurement attempts to answer the real question, “Just how long will it take me to get back to where I was if the bottom falls out?”
Obviously, a 68% drawdown that lasts for 20 years is not a smart risk for most people to take in their retirement portfolios when they get to be in their 50s or above. That is more appropriate for those in their 20s or 30s who are decades away from retirement.
One of the more damaging effects that drawdown risk can have is that those who are hit with a hard loss will often be forced to sell their depressed holding at a substantial discount if they need to reallocate this month into something safer. Furthermore, they will not even be able to claim this as a taxable loss if it happens inside a tax-deferred retirement plan. This double whammy can serve as a warning for older investors who carry aggressive holdings in their portfolios.
Although they should still probably have at least some exposure to equities in their holdings, they need to understand the real impact that a severe market downturn can have on their lifestyle. This effect can often be seen in the maximum drawdown, which is the largest price drop that an investment has experienced since its inception. For example, if a mutual fund in your portfolio dropped in value by two-thirds during the Subprime Meltdown in 2008, has it recouped those losses yet? And will you have time to let it grow back again if the market were to experience a similar correction this year?
Learn more about the 7 Behavioral Biases Mutual Fund Investors Must Avoid.
The Bottom Line
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