People experience risk as a visceral reaction in the form of anxiety, anger and depression related to a sense of loss. The drawdown is a graphic way of showing this experience. The peak to trough drawdown is shown by plotting the last high water mark of a data series as 0 and showing how declines unfold before equalling or creating a new high water mark.
The drawdown tool only makes sense with an ever increasing time series. Quantitative analysts use volatility to express risk, but many decisions are made based on perceptions. Drawdown is a good way of understanding those perceptions and the patience that may be required with paper loss experience. Being a value investor helps some people to ignore price fluctuations while they focus on intrinsic value.
Plotting a drawdown series is also a good way to understand what holding an asset may feel like. 20 years can seem like a long time to get up to break even. The graph below doesn’t include dividend payments or the impacts of inflation on purchasing power of the asset.
The graph below is taken from a full article available on Seeking alpha entitled The trillion dollar trading system 1871-2011.