What is a maximum drawdown or Maximum Drawdown (MDD)?

A maximum drawdown (MDD) is the maximum loss observed from a peak to a trough in a portfolio, before a new peak is reached, as illustrated in the figure. Maximum drawdown is an indicator of downside risk over a given period of time.

It can be used either as a stand-alone measure or as an input into other metrics such as Return over Maximum Drawdown and Calmar Ratio. Maximum Drawdown is expressed in percentage terms.

Understanding maximum drawdown

Maximum drawdown is a specific measure of drawdown that looks for the largest movement from a high point to a low point before a new peak is reached. 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 maximum drawdown, the MDD does not indicate how long it took the investor to recover from the loss, or whether the investment recovered at all.

Maximum drawdown (MDD) is an indicator used to assess the relative risk of one equity screening strategy versus another, as it focuses on capital preservation, which is a key concern for most investors. For example, two screening strategies may have the same average outperformance, tracking error and volatility, but their maximum drawdowns against the benchmark may be very different.

A low maximum drawdown is preferable as it indicates that the losses from the investment were small. If an investment never lost a penny, the maximum drawdown would be zero. The worst possible maximum drawdown would be -100%, which means that the investment is completely worthless.

The MDD should be used in the right perspective to reap the maximum benefit. In this regard, special attention should be paid to the time period considered. For example, a hypothetical American long-only Gamma fund has existed since 2000 and had a maximum drawdown of -30% in the period ending in 2010. While this may seem like a huge loss, it should be noted that the S&P 500 fell more than 55% from its peak in October 2007 to its low in March 2009. While other metrics should be considered to assess the Gamma fund’s overall performance, from an MDD perspective, it has outperformed its benchmark by a huge margin.

Example of maximum drawdown

Let’s consider an example to understand the concept of maximum drawdown. Suppose an investment portfolio has an initial value of $500,000. The portfolio rises to $750,000 over a period of time, before plummeting to $400,000 in a fierce bear market. It then rebounds to $600,000, before falling again to $350,000. Subsequently, it more than doubles to $800,000. What is the maximum drawdown?

$$ MDD = \frac{350.000 - 700.000}{700.000} $$ $$ MDD=-53.33 % $$

The following points should be noted:

• The initial peak of $750,000 is used in the MDD calculation. The intermediate peak of $600,000 is not used since it does not represent a new maximum.
• The new peak of $800,000 is also not used since the original drawdown started at the $750,000 peak.
• The MDD calculation takes into account the lowest value of the portfolio ($350,000 in this case) before a new peak, and not just the first drop to $400,000.

Source of this article: www.investopedia.com