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Maximum Drawdown (MDD)

Step-by-Step Guide to Understanding Maximum Drawdown (MDD)

Last Updated February 20, 2024

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Maximum Drawdown (MDD)

What is the Definition of Maximum Drawdown?

The maximum drawdown, or “MDD”, is a metric that tracks the most significant potential percentage decline in the value of a portfolio over a given period.

Conceptually, the maximum drawdown identifies the peak value and trough value of a portfolio or single investment, i.e. the volatility risk.

Investment firms, such as hedge funds and mutual funds, monitor the maximum drawdown of their portfolio as a method of quantifying downside risk and having a historical precedence to reference.

The question answered by the maximum drawdown from a backward-looking perspective is, “What is the maximum percentage decline in the value of a given portfolio from the peak value to date?”

Based on the historical drawdown to date, a firm can adjust their investment strategy to reduce the downside risk potential of its portfolio going forward.

However, the MDD of the portfolio being analyzed is more meaningful for portfolios with long standing performance data.

Why? The portfolio has most likely undergone, at a bare minimum, one full economic cycle, including one major recessionary period, i.e. “bear market”.

How to Calculate Maximum Drawdown?

The maximum drawdown of a portfolio is predicated on two data points:

  1. Peak Value of Portfolio
  2. Trough Value of Portfolio

The inputs to the MDD formula are thus the lowest and highest points in the value of a portfolio, which are used to calculate the most significant percent drop off in the portfolio’s value.

The steps to compute the maximum drawdown of a portfolio are as follows.

  1. Identify Peak Value of Portfolio
  2. Identify Trough Value of Portfolio
  3. Subtract Trough Value by Peak Value of Portfolio
  4. Divide Difference (Trough – Peak) by Peak Value
  5. Multiply by 100 to Convert into Percentage

If calculating the maximum drawdown in Excel, ensure the formula is dynamic to capture each new peak and restart of the cycle, i.e. on a “rolling basis”.

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Maximum Drawdown Formula

The maximum drawdown formula is as follows.

Maximum Drawdown (MDD) = (Trough Value  Peak Value) ÷ Peak Value

Where:

  • Trough Value – Lowest Portfolio Value (“Bottom”)
  • Peak Value – Highest Portfolio Value (“Top”)

To convert the output into a percentage, multiply the resulting figure by 100.

For example, if an investment portfolio was worth $100 million at its peak, which subsequently declined to $50 million amid a recession, the maximum drawdown would be 50%, i.e. decline from $100 million to $50 million.

  • Maximum Drawdown (MDD) = ($50 million – $100 million) ÷ $100 million

Maximum Drawdown Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Excel Template

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Maximum Drawdown Calculation Example

Suppose a hedge fund is measuring its maximum drawdown from the start of 2006 to the end of 2008.

The historical portfolio value data – wherein the value of the portfolio value is based on the end of each month – is as follows.

Date Portfolio Value
01/31/2006 $160 million
02/28/2006 $150 million
03/31/2006 $165 million
04/30/2006 $150 million
05/31/2006 $158 million
06/30/2006 $180 million
07/31/2006 $185 million
08/31/2006 $175 million
09/30/2006 $182 million
10/31/2006 $186 million
11/30/2006 $194 million
12/31/2006 $200 million
01/31/2007 $198 million
02/28/2007 $194 million
03/31/2007 $197 million
04/30/2007 $190 million
05/31/2007 $188 million
06/30/2007 $179 million
07/31/2007 $165 million
08/31/2007 $161 million
09/30/2007 $154 million
10/31/2007 $145 million
11/30/2007 $138 million
12/31/2007 $130 million
01/31/2008 $125 million
02/29/2008 $126 million
03/31/2008 $120 million
04/30/2008 $131 million
05/31/2008 $134 million
06/30/2008 $130 million
07/31/2008 $139 million
08/31/2008 $145 million
09/30/2008 $144 million
10/31/2008 $148 million
11/30/2008 $150 million
12/31/2008 $140 million

Note: Ideally, the historical data of the portfolio value should be longer, but the exercise here is only intended for illustrative purposes.

Using the “MAX” function in Excel, the array will contain the portfolio value in the current period and the peak value to date.

=MAX(Current Value, Peak Value)

The peak value is $200 million, which was reached at the end of 2006 (12/31/2006).

In the next step, the drawdown will be determined by subtracting the peak value from the portfolio value in the current period.

=IF(Current Value<Peak Value, Current Value Peak Value, “NA”)

From there, we’ll also compute the % drawdown by dividing the drawdown amount – the difference between the current portfolio value and the peak value – by the peak value to date.

The peak portfolio value is $200 million, whereas the trough portfolio value is $120 million, which we highlighted using conditional formatting.

Upon dividing the difference between the trough and peak value, we calculate a maximum drawdown of 40% for the three-year period.

  • Maximum Drawdown (%) = ($120 million – $200 million) ÷ $200 million = (40.0%)

Maximum Drawdown Calculator

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