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Maximum drawdown (MDD) is the maximum observed loss from peak to bottom of the portfolio, before reaching a new peak. The maximum drawdown is an indication of downside risks over a specified period of time.

It can be used as a standalone metric or as an input to other metrics such as “return over maximum withdrawal” and the Calmar ratio. The maximum drawdown is expressed in terms of percentage.

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The equation for maximum regression is

MDD =

Peak value

Trough value – the maximum value

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Understand the maximum drawdown

The maximum drawdown is a specific measure of retracement that looks for the largest movement from a high to a low, before reaching a new high. However, it is important to note that it only measures the size of the largest loss, without taking into account the frequency of large losses. Since it only measures the largest decline, the MDD does not indicate how long it took the investor to recover from a loss, or whether the investment recovered at all.

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Maximum Drawdown (MDD) is an indicator used to assess the relative risk of one stock check strategy against another, as it focuses on capital preservation, and is a major concern of most investors. For example, two screening strategies can have the same average outperformance, tracking error, and volatility, but the maximum regression compared to benchmark may be very different.

The lower limit is preferred as this indicates that losses from the investment were small. If the investment did not lose a penny, the maximum drawdown would be zero. The worst possible drawdown would be 100%, which means the investment is absolutely worthless.

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MDD must be used in the right perspective to get the most benefit from it. In this regard, special attention should be paid to the time period under consideration. For example, the US gamma default long-term fund has been around since 2000, and the maximum drawdown from it was -30% in the period ending 2010. While this might appear like a heavy loss, note that the S&P 500 has declined further. More than 55% from its October 2007 peak to its lowest level in March 2009. While other metrics should be taken into account to assess the overall performance of the Gamma Fund, from the point of view of MDD, it outperformed by a huge margin.

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The main concerns

Maximum Drawdown (MDD) is a measure of the largest decline in an asset’s price from high to low.

The maximum drawdown is an indication of downside risk, as the larger MDDs indicate that bearish moves can be volatile.

While MDD measures the largest loss, it does not take into account the frequency of losses, not the magnitude of any gains.

Example of maximum drawdown

Consider an example to understand the concept of maximum drawdown. Assume an investment portfolio has an initial value of $ 500,000. The portfolio increased to $ 750,000 over a period of time, before dropping to $ 400,000 in a fierce bear market. It then bounces to $ 600,000, before dropping again to $ 350,000. Consequently, it doubled to $ 800,000. What is the maximum drawdown?

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The maximum drawdown in this case is

=

$ 750K = 53.33%

$ 350,000 to $ 750,000

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Note the following points:

The initial peak of $ 750,000 is used for the MDD account. The temporary peak of $ 600,000 has not been used, as it does not represent a new high. The new peak of $ 800,000 has also not been used since the original drawdown of the $ 750,000 peak began.

The MDD account takes into account the lowest portfolio value ($ 350,000 in this case) before reaching a new peak, not just the first drop to $ 400,000.

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