By comparing the highest value and the lowest value of your portfolio over a given period, we define the drawdown. This is the maximum loss incurred or probable on an investment.
For example, you bought €100 in Bitcoin. After a month, the value of Bitcoin fluctuated. During the fluctuations, the highest value of your investment was €110 and a few days later the lowest value of your investment was €95. throughout the month, your small portfolio has remained between these 2 values.
Your drawdown during this period is then:
- (110-95)/110 = 0.1363 or 13.63%.
A drawdown is calculated when the value of an investment falls below the highest peak observed during the investment period. We can also calculate the drawdown taking into account your closed positions.
The drawdown can be a volatility indicator. The larger it is, the more it shows that the markets are turbulent. But it doesn’t just depend on the market. The size of your positions in relation to your total balance is something to consider. The larger your positions, the more pronounced the drawdown.
The bigger the drawdown, the harder it will be to recover!
Your ability to bounce to new heights is the main reason you absolutely need to manage your drawdowns and make sure they’re minimal. One of the most difficult components of investing is the asymmetry of performance on the downside.
To recover from a 10% drawdown, i.e. bring your portfolio back to its highest level, you need to generate a return of 11% (not 10%). To recover from a drawdown of 50%, you must perform 100% (and not 50%) on the equity still available!
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As shown in the table below, the situation becomes critical if your drawdown becomes more substantial.
Source : stock exchange
How to avoid too severe a drawdown?
1. Invest in a variety of asset types
One of the best methods to avoid severe losses is diversification. Indeed, all instruments do not fall at the same rate. Many bond funds and ETFs are in the green in 2022, unlike the equity and crypto markets as a whole.
2. Make frequent small investments rather than one large investment.
Investors face greater downside risk when making a large single investment. Imagine if you had invested a large part of your savings in Bitcoin in November 2021!
This is why the DCA method can be of great help to investors.
3. Avoid using leverage
Traders using excessive leverage have much larger drawdowns. Your account could be wiped out by a 10% loss on a position that uses excessive leverage.
Unfortunately, crypto traders turn to futures, options or other complex products if they don’t see enough movement in the markets. They accelerate their losses most of the time.