By Warren Mackenzie on November 8, 2013
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 full 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, only those investors who fully reinvested the fund’s distributions have recovered – and only as of October 2013 on a total return basis. So even these patient investors would have been under water for about 5.5 years. By comparison, the S&P/TSX Composite Total Return Index briefly hit a new high in early 2011 before slumping a bit that year and hitting another new high this fall.
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.
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