What Is Maximum Drawdown?
In quantitative finance, maximum drawdown (MDD) refers to the maximum loss from a peak to a trough of a portfolio, before a new peak is attained. It is a measure of the largest loss that an investment portfolio has experienced over a specified time period.
Maximum drawdown is an important metric in risk management as it helps investors understand the potential downside risk of an investment. It is often used to assess the risk of a portfolio and to compare different investment strategies.
For example, suppose an investment portfolio has a maximum drawdown of 20%. This means that the portfolio has experienced a loss of 20% from its peak value before a new peak is reached. In other words, the portfolio has lost 20% of its value at some point in the past.
Maximum drawdown is typically expressed as a percentage of the portfolio’s value. It can be calculated using the following formula:
where P is the peak value of the portfolio and T is the trough value.
As a rule of thumb, the maximum drawdown should not be more than 1/3 of the strategy annual returns. For example, if a strategy has an annual return of 30%, the maximum drawdown should not exceed 10%.