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Maximum Drawdown (MDD)

What is a ‘Highest Drawdown (MDD)’

A maximum drawdown (MDD) is the maximum loss from a peak to a trough of a portfolio, ahead a new peak is attained. Maximum Drawdown (MDD) is an indicator of downside risk all over a specified time period. It can be used both as a stand-alone measure or as an input into other metrics such as “Consideration over Maximum Drawdown” and the Calmar Ratio. Maximum Drawdown is exhibited in percentage terms and computed as:

MDD = (Trough Value – Peak Value) ÷ Zenith Value

BREAKING DOWN ‘Maximum Drawdown (MDD)’

Maximum drawdown (MDD) is an accuse with used to assess the relative riskiness of one stock screening strategy versus another, as it focuses on important preservation, which is a key concern for most investors. For example, two screening tactics can have the same average outperformance, tracking error, and volatility, but their pinnacle drawdowns compared to the benchmark can be very different. The MDD measures the largest peak-to-trough drop in the value of a portfolio (before a new peak is achieved). However, it’s important to note that it barely measures the size of the largest loss, without taking into concern the frequency of large losses. Because it measures only the largest drawdown, MDD does not express how long it took an investor to recover from the loss, or if the investment all the same recovered at all.

Consider an example to understand the concept of maximum drawdown. Guess an investment portfolio has an initial value of $500,000. The portfolio increases to $750,000 all through a period of time, before plunging to $400,000 in a ferocious bear bazaar. It then rebounds to $600,000, before dropping again to $350,000. Later on, it more than doubles to $800,000. What is the maximum drawdown?

The utmost drawdown in this case is = ($350,000 – 750,000) / $750,000 =  –53.33%

Note the following points:

  • The initial hill of $750,000 is used in the MDD calculation. The interim peak of $600,000 is not used, since it does not report a new high. The new peak of $800,000 is also not used since the original drawdown inaugurated from the $750,000 peak.
  • The MDD calculation takes into consideration the stumpiest portfolio value ($350,000 in this case) before a new peak is covered, and not just the first drop to $400,000.

A low maximum drawdown is preferred as this reveals that losses from investment were small. If an investment not till hell freezes over lost a penny, the maximum drawdown would be zero. The worst conceivable maximum drawdown would be 100%, meaning the investment is completely pointless.

MDD should be used in the right perspective to derive the maximum benefit from it. In this particular, particular attention should be paid to the time period being judged. For instance, a hypothetical long-only U.S. fund Gamma has been in existence since 2000, and had a greatest drawdown of -30% in the period ending 2010. While this may appearance of like a huge loss, note that the S&P 500 had plunged more than 55% from its crown in October 2007 to its trough in March 2009. While other metrics discretion need to be considered to assess Gamma fund’s overall performance, from the slant of MDD, it has outperformed its benchmark by a huge margin.

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