Maximum Drawdown (MDD)
Candlefocus EditorMDD is calculated by subtracting a peak from a trough in the value of an investment or portfolio. The MDD is measured from the highest peak-to-through point, meaning that the peak and trough could be over a long period of time. The peak is the highest historical point of the asset's value, while the trough is the lowest point. The maximum drawdown is the difference between these two points.
For example, consider a stock whose price had risen to $100. If the price of the stock subsequently falls to $90, its maximum drawdown is 10%. If the stock continues to fall and hits a trough of $80, then the MDD should be $20, or 20%.
Typically, a high maximum drawdown indicates an asset that is riskier, as there is more potential for losses. An asset that experiences large drawdowns is especially prone to risk of permanent loss of capital, as it may be difficult to recover from large drops in value. Furthermore, frequent drawdowns can signal that the portfolio or investment strategy might need to be adjusted or rebalanced to mitigate risk.
In contrast, an asset with a low maximum drawdown is generally considered to be less risky, as drawdowns are unlikely to be permanent. However, it is important to keep in mind that MDD does not take into account the frequency of drawdowns, or the potential for gains.
Overall, maximum drawdown is an important tool for measuring risk. It is important to understand both maximum drawdown and drawdown frequency when constructing a portfolio. A combination of both low-risk, low-MDD assets and high-return, high-MDD assets can help reduce portfolio risk while still maximizing returns.