Investing with the Trend: A Rules-based Approach to Money Management

Chapter 11Drawdown Analysis

While the world of finance believes risk is measured by volatility (standard deviation), it is my belief that loss of capital is risk and not volatility. In Figure 11.1, example A ends where it begins with zero gain or loss, yet modern finance says it is risky because it is volatile. Example B shows the end price lower than the beginning price so it shows a loss. Modern finance, in this instance, would say there is no risk because there is no volatility. I think you can draw your own conclusions. Volatility can contribute to risk, but it also can contribute to price gains. Loss of capital is simple and reasonable to use as a risk measure, and in this chapter, risk is defined by drawdown.

FIGURE 11.1 Volatility versus Risk

What Is Drawdown?

Drawdown is the percentage that price has moved down from its previous all-time high price.

1. Drawdown is risk.
2. Drawdown is systematic risk.
3. Drawdown is loss of capital.
4. Drawdown can last longer than you can.
5. Drawdown can ruin your retirement plans.

Drawdown Terminology

The following describes the nomenclature used in Figure 11.2.

FIGURE 11.2 Drawdown Terminology Chart

Source: Chart courtesy of MetaStock.

1. Magnitude: Drawdown Magnitude is the percentage that price has moved down from its previous all-time ...