What is a Maximum Drawdown?
A maximum drawdown (MDD) measures the maximum fall in the value of the investment, as given by the difference between the value of the lowest trough and that of the highest peak before the trough. MDD is calculated over a long time period when the value of an asset or an investment has gone through several boom-bust cycles. It is calculated as:
- Maximum drawdown (MDD) measures the maximum fall in the value of the investment, as given by the difference between the value of the lowest trough and that of the highest peak before the trough.
- By measuring the difference between the highest peak and the lowest trough values of an investment, MDD shows the volatility of its value in the past, which provides an almost accurate way of predicting future price movements.
- In addition to associated risk, maximum drawdown also acts as an indicator for market performance.
Maximum Drawdown as a Measure of Investment Risk
In broad terms, investment risk refers to the possibility of incurring losses on one’s investment. It can be due to a decline in the market value of the asset or general market turbulence caused by external factors. Maximum drawdown is often used to measure the associated risk with a certain asset or a portfolio made up of a basket of assets.
By measuring the difference between the highest peak and the lowest trough values of an investment, MDD shows the volatility of its value in the past, and it provides an almost accurate way of predicting future price movements.
A low MDD value indicates slight fluctuations in the value of the investment and, therefore, a lesser degree of risk, and vice versa. While comparing two investment options, an investor who wishes to receive the guarantee of stable returns would most likely choose the option with the lower MDD value. On the other hand, another investor who is willing to take up a higher risk in return for a higher return would choose assets with higher MDD values.
In addition to associated risk, maximum drawdown also acts as an indicator of market performance. The maximum drawdown for an asset can be compared to that for a stock market index in order to evaluate the asset’s performance relative to the market. If the MDD of an individual stock is less than that of its benchmark index, it means that the former outperformed the index, even if the MDD value of the stock is high in absolute terms.
For example, the MDD of Tata Motors is high at -40% over a certain time period, and that of its benchmark index, NIFTY, is -50%. Despite a high absolute value, the stock of Tata Motors performed better than the market.
Drawdown Optimized Portfolio
Investors ultimately aim to own the best portfolio of assets that offers the highest expected returns and the lowest associated risk. Using drawdown to construct such a portfolio is an effective way to ensure investing in a profitable venture.
Portfolio optimization determines a basket of high-quality assets based on their expected returns and volatilities. By substituting MDD for their respective volatilities, a basket of assets can be created with the least values of MDD. Such a portfolio will show the lowest volatility levels among different asset combinations.
In fact, a drawdown optimized portfolio not only offers low drawdown levels but also ensures that the average time taken for the asset to regain a new peak is under two years, before the drawdown. It is important since investors want to determine how much time it will take for their investments to regain a high value after a downfall.
CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: