Maximum Drawdown (MDD)

Maximum drawdown (MDD) measures the largest decline in an investment’s value from a historical peak to the subsequent trough before a new peak is reached. It highlights downside risk and the worst loss an investor would have experienced over a specified period.

Why MDD matters

• Shows the most severe single loss over a time horizon — useful for assessing capital preservation.
• Helps compare the riskiness of strategies or funds even when returns, volatility, or tracking error are similar.
• A lower MDD is generally preferable; an MDD of -100% means the investment became worthless.

Definition and formula

Drawdown can be expressed as a negative percentage (loss) or as a positive magnitude.

Negative drawdown (loss):
MDD = (Trough Value − Peak Value) / Peak Value

Magnitude of the decline (absolute loss):
MDD magnitude = (Peak Value − Trough Value) / Peak Value

Both expressions describe the same movement; the first yields a negative percentage (e.g., −53.33%), the second a positive percentage representing the size of the loss (e.g., 53.33%).

How it works

• Identify a peak value (a historical high).
• Find the lowest value reached after that peak before any new peak occurs.
• Compute the percentage decline from the identified peak to that trough.
• The maximum drawdown is the single largest such decline over the period analyzed.

Important: MDD captures the largest loss magnitude but does not indicate how often losses occur or how long recovery takes.

Example

A portfolio evolves as follows:
* Starts: $500,000
Rises to a peak of $750,000
Falls to $400,000, then rebounds to $600,000
Falls again to $350,000 (trough)
Later rises to a new peak of $800,000

The relevant peak for the maximum drawdown is $750,000 (the high before the trough of $350,000). The MDD is:

MDD = (350,000 − 750,000) / 750,000 = −0.5333 → −53.33%

Or expressed as magnitude: (750,000 − 350,000) / 750,000 = 53.33%.

Notes:
* The interim peak of $600,000 is not a new high, so it does not reset the drawdown measurement.
* The later new peak of $800,000 occurs after the trough and does not affect the MDD that began at $750,000.

Limitations and practical considerations

• Time period dependence: MDD varies with the sample period—comparing funds requires consistent timeframes.
• No timing information: MDD does not reveal how long the drawdown lasted or how quickly recovery occurred.
• Complement with other metrics: Use MDD alongside volatility, Sharpe or Calmar ratios, recovery time, and frequency of losses for a fuller risk assessment.
• Investor context: Different investors tolerate different MDDs depending on horizon, liquidity needs, and risk tolerance.

Use cases

• Risk comparison between strategies or funds.
• Inputs to risk-adjusted performance ratios (e.g., Return/Maximum Drawdown, Calmar Ratio).
• Stress-testing portfolios and setting drawdown-based guardrails for portfolio risk management.

Summary

Maximum drawdown is a straightforward, intuitive measure of the worst historical loss from peak to trough. It’s a valuable tool for assessing downside risk and capital preservation but should be used alongside other metrics and interpreted in the context of the chosen time period and the investor’s objectives.