Drawdown: the more practical risk metric for long term investors
For long-term investors, drawdown is often a more intuitive and practical risk metric than volatility, because it directly measures the worst-case loss from peak to trough (as a percentage) and highlights recovery challenges.
Let's take the example of Anheuser-Busch Inbev, if you look at the graph below - you see a 74.8% drop from the peak in November 2015 to the lowest point in March 2020 which represents a drawdown of 74,8% and the stock never reached this same peak...
Formula for calculating drawdown:
with:
- Peak value: highest value of the asset (or portfolio of assets) in a specific time period
- Trough value:lowest value reached after the peak
Why drawdown resonates more for long-term investors?
- Highlights behavioral impact: Investors often panic-sell during deep drawdowns, leading to permanent losses. Volatility alone doesn't capture this behavioral risk. But even with drawdown awareness, investors may still panic and sell.
- Importance of capital preservation: A 50% drawdown requires a 100% gain to recover. This asymmetry isn't always understood
- Portfolio resilience: maximum drawdown is a key metric for stress-testing strategies and ensuring investors can withstand downturns without jeopardizing lifestyle.
Even though drawdown is the more "real-world" metric because it reflects the actual pain of losses and recovery requirements, it is still useful to also use volatility for portfolio construction and relative risk comparison.
Also keep in mind that past drawdowns don't guarantee future outcomes, structural changes in markets can change the risk profile of a particular asset.
References:
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