Drawdown is a strategy to determine the financial risk of an investment by tracking its peaks and valleys. It is commonly used with commodities and measured by the Calmar, Sterling, and Burke ratios to assess downside risk and excess return. The calculation helps investors project future movements and assess an investment’s potential.
A drawdown is a strategy used to determine the amount of financial risk that is associated with a particular investment. The basic process involved in this strategy is to take into account the peaks and valleys of investment movement within a given period of time. In most settings, tracking this movement is described as a peak-to-trough analysis, simply meaning that the valuation moves from the high point of the investment’s performance to the lowest point and follows your progress as the investment begins to decline. to recover. Generally, a withdrawal is presented as a percentage and not an actual dollar amount.
The use of the drawdown strategy can be employed with virtually any type of investment opportunity, but is most commonly employed with commodities. Various types of performance measures are used in determining this trend and the resulting percentage. Typically, the measures used are the Calmar ratio, the Sterling rate and the Burke rate. Some may choose to use one of these measures or perform the calculation using each of the three in hopes of discovering additional data that may be helpful in making investment decisions.
The Calmar ratio is useful when assessing the degree of downside risk with a hedge fund and takes into account the relationship between the compound annual return and the drawdown. Typically, a three-year period is considered when employing this approach. The Sterling ratio is also useful with hedge funds and focuses on the relationship of the compound annual return and the maximum drawdown, minus ten percent. The Burke ratio takes a slightly different approach in that it focuses on the amount of excess return associated with the investment divided by the square root of the total of the largest squared drawdown.
The end result of the drawdown calculation is to determine the degree of risk associated with the investment. This makes it much easier to determine the potential for a certain reduction in equity associated with the investment within a given time period and to use this data to project future movements. While the data collected and used to determine drawdown is very helpful, investors will typically use this approach as one of several ways to assess an investment’s potential. As with most formulas for assessing the potential of commodities or other securities, there is a need to allow for factors that were not relevant to past performance but that may have some sort of effect in the future.
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