Maximum Drawdown
Quick Definition
The largest peak-to-trough decline in portfolio value before a new peak is reached, measuring worst-case loss.
What Is Maximum Drawdown?
Maximum Drawdown (MDD) measures the largest percentage decline from a peak to a trough before a new peak is established. It represents the worst-case loss an investor would have experienced.
Formula: MDD = (Trough Value - Peak Value) / Peak Value × 100
Example:
- Portfolio peaks at $100,000
- Falls to $60,000 (trough)
- Recovers to $110,000 (new peak)
- Maximum Drawdown = ($60,000 - $100,000) / $100,000 = -40%
Why It Matters:
- Shows actual worst-case experience
- Tests psychological resilience
- More intuitive than standard deviation
- Indicates recovery requirement
Recovery Math:
| Drawdown | Gain Needed to Recover |
|---|---|
| -10% | +11.1% |
| -20% | +25.0% |
| -30% | +42.9% |
| -50% | +100.0% |
| -75% | +300.0% |
Historical MDD Examples:
- S&P 500 (2008-09): ~-56%
- NASDAQ (2000-02): ~-78%
- Average bear market: ~-30%
Uses:
- Risk Assessment: Understand potential losses
- Strategy Evaluation: Compare trading systems
- Position Sizing: Size positions to survive MDD
- Calmar Ratio: Return / Max Drawdown
Limitations:
- Backward-looking (future could be worse)
- Single data point (doesn't show frequency)
- Time-dependent (longer history = larger MDD likely)
Formula
Formula
MDD = (Trough - Peak) / Peak × 100Maximum Drawdown Example
- 12008 financial crisis caused 50%+ drawdowns in many portfolios
- 2Strategy with 20% max drawdown is more conservative than one with 40%
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Standard Deviation
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Hedging
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Value at Risk (VaR)
A statistical measure estimating the maximum potential loss over a specific time period at a given confidence level.
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