Maximum Drawdown

Maximum Drawdown is one of the key measures to assess the risk in a portfolio. In your trading or investment period, your portfolio reduces in value multiple times. These reductions in value are known as drawdowns. The maximum of these drawdown values gives us an estimate of maximum loss a portfolio can incur. Technically, it is defined as the maximum loss from peak to trough for a portfolio.

It can be expressed in the formula as :

where,

P = Maximum value before the largest drop 

L = Lowest value before the new high


Example

Let’s say your portfolio has an initial value of $10,000. It increases to $50,000 over a period of time, before falling to $7500. It then rebounds to $55,000, before falling again to $48,000. The maximum drawdown, in this case, is

                                    (7500 – 50000) / 50000 = -85%.

Applications

The maximum drawdown is used to assess the risk of a portfolio. A low value of maximum drawdown is preferred as it indicates that losses from investment in the portfolio are less. In other words, there won’t be any significant loss of your capital.  This feature is sought by large institutional investors. 
 

Limitations

The maximum drawdown only measures the size of the largest loss. It doesn't say how frequently the losses are occurring and how much time it took to recover from those losses. Therefore, you can consider plotting the drawdowns chart. This can help you to visualize the frequency of drawdowns and the time period of each drawdown.


                                                  Source: Quantitative Portfolio Management course