What is Maximum Drawdown?
The Maximum Drawdown (MDD) quantifies the maximum downside risk of an investment portfolio across a given time period.
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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:
- Peak Value of Portfolio
- 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.
- Identify Peak Value of Portfolio
- Identify Trough Value of Portfolio
- Subtract Trough Value by Peak Value of Portfolio
- Divide Difference (Trough – Peak) by Peak Value
- 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”.