Maximum Drawdown

Maximum drawdown (MDD) refers to the most significant percentage decline in the value of an investment or portfolio from its highest point to the subsequent lowest point before recovering to a new peak. It is a financial metric that measures the risk and volatility associated with financial products.

Maximum Drawdown (MDD) is a key indicator used by investors and traders to assess the downside risk of a security. By analyzing MDD, they can evaluate investment volatility, performance, and potential capital preservation. This metric aids in formulating effective asset allocation strategies and making informed investment decisions that minimize risk and maximize profitability.

• Maximum drawdown (MDD) refers to a technical, financial indicator of the highest percentage drop in the value of an investment portfolio from the peak value before an increase.
• It calculates the potential downside risk of an investment as: * 100.
• The Max DD is a crucial metric investors, traders, and other market participants use to decide their investment and asset allocation strategies for calculating risk and maximizing returns.

Maximum drawdown is a widely used measure in finance for gauging the potential risk and loss associated with an investment or portfolio. For the organization, it facilitates stress testing and determination of capital reserve requirements. For individuals, it aids in employing risk management strategies, asset allocation, and retirement planning.

Moreover, in the forex market, MDD below 5% is optimal; however, it should be at most 20% - 25% in retail trading to avoid high risk exposure. Hence, it is a tool that facilitates investors and traders to devise suitable strategies and make wise decisions to mitigate the financial market risk and maximize returns.

The following steps facilitate the evaluation of the maximum drawdown of an investment portfolio in a given time frame:

1. Determine the peak value of the investment or portfolio during the selected period.
2. Find the lowest point when the value drops after a high. It represents the trough of the drawdown.
3. Compute the drawdown by subtracting the peak value from the lowest point value.
4. Divide the drawdown value by the peak value and multiply by 100 to obtain the drawdown as a percentage.
5. To calculate drawdown (MDD) over multiple periods, repeat the process for each period and select the highest drawdown value.

Traders and investors with a low-risk appetite often select portfolios with a low max drawdown and vice-versa. Although, diversifying an investment portfolio can help reduce the impact of high MDD. Such a metric even helps in making tactical asset allocation decisions. If MDD is increased, traders can adopt other strategies like stop-loss orders and portfolio insurance to reduce the risk. However, this measure fails to determine the drawdown distribution shape and doesn't provide adequate insights into the duration and frequency of loss.

Let's understand how to calculate the maximum drawdown (MDD) of an investment portfolio with the help of the following formula:

MDD=(L - P) / P * 100

Where P denotes the peak value, I.e., the highest price point of a portfolio in a given period beyond which the value starts declining again;

Also, L represents the lowest point or trough value to which a portfolio price falls in a given period before it increases again.

Since MDD gauges the drop in the portfolio value, it is often represented as a negative percentage value.

Let us understand maximum drawdown through some real-life examples and calculations.

Example #1

Consider an example of an investment portfolio over a specific period to understand the concept clearly:

Solution

We must identify the peak and lowest points to calculate drawdown (MDD).

In this case:

Peak Value = $11000

Lowest Point = $8800

MDD = * 100

MDD = * 100 = -20%

Therefore, the maximum drawdown for this investment portfolio is 20%, signifying the most significant percentage decline in value from its peak to its lowest point in the given period.

Example #2

Let us take the example of Tesla Inc. The peak value was $264.61 on June 23, 2023, and the lowest was $241.05 on June 26, 2023. According to the information on Google Finance, the peak value on June 23, 2023, was $264.61, while the lowest point on June 26, 2023, was $241.05.

Using the formula for MDD, we can determine the drawdown:

MDD = * 100 = * 100 = -8.9%

Therefore, during the specified period, the downside risk of Tesla Inc. was calculated to be 8.9%, indicating the maximum percentage decline in value from the peak to the lowest point.

Maximum Drawdown, Relative Drawdown, and Absolute Drawdown are metrics commonly used to assess the risk and performance of investment portfolios. However, their relevance and use differ in the following ways:

This article has been a guide to Maximum Drawdown and its meaning. We explain it with its examples, formula, and comparison with relative and absolute drawdowns. You may also find some useful articles here -

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