Measure the largest peak-to-trough decline in your portfolio. Understand the worst-case scenario and the recovery needed to get back to breakeven.
Maximum drawdown (MDD) is a risk metric that measures the largest peak-to-trough decline in a portfolio's value before a new peak is reached. It represents the worst-case scenario an investor would have experienced during a specific time period, expressed as a percentage from the highest point to the lowest point.
For example, if a portfolio grows from $10,000 to $15,000 and then falls to $11,000 before recovering, the maximum drawdown is ($15,000 - $11,000) / $15,000 = 26.67%. This tells you that at the worst point, the portfolio had lost 26.67% of its peak value. Maximum drawdown captures the pain an investor would have felt at the lowest point, making it one of the most intuitive and widely used risk measures in portfolio management.
Maximum drawdown is essential for evaluating the real-world risk of any trading strategy or investment approach. While metrics like standard deviation treat upside and downside volatility equally, drawdown focuses specifically on losses, which is what investors care about most. Before implementing any strategy — whether it's a RSI-based approach or a MACD crossover system — understanding its maximum drawdown helps you assess whether you can psychologically and financially handle the worst-case scenario. Here is why it matters:
Maximum drawdown is one of several risk metrics used to evaluate portfolio performance. Each metric captures a different aspect of risk, and they are most useful when considered together.
| Metric | What It Measures | Best For |
|---|---|---|
| Max Drawdown | Largest peak-to-trough decline in portfolio value over a period | Understanding worst-case loss scenarios and recovery requirements |
| Sharpe Ratio | Risk-adjusted return relative to total volatility (standard deviation) | Comparing overall risk-adjusted performance across different strategies |
| Sortino Ratio | Risk-adjusted return relative to downside deviation only | Evaluating performance when you only care about downside risk, not upside volatility |
| Standard Deviation | Overall volatility of returns, both up and down | Measuring general return dispersion and predicting the range of future outcomes |
Generally, drawdowns under 20% are acceptable for most strategies. Conservative strategies typically aim for drawdowns below 10%, while aggressive growth strategies may tolerate drawdowns of 30-40%. The acceptable level depends on your risk tolerance, investment time horizon, and the strategy's expected return. A useful rule of thumb is that the maximum drawdown should not exceed your expected annual return by more than 2x. Historically, even broad market indices like the S&P 500 have experienced drawdowns exceeding 50%, so context and strategy type matter significantly.
Track the running peak of your portfolio value over time. At each data point, calculate the percentage decline from the highest peak reached so far to the current value using the formula: Drawdown = (Peak - Current Value) / Peak x 100%. The maximum drawdown is the largest percentage decline observed across all data points. For example, if your portfolio peaked at $10,000 and later dropped to $7,500 before recovering, the drawdown at that trough was 25%. If no other point experienced a larger percentage decline from its respective peak, the maximum drawdown is 25%.
The recovery percentage is the gain needed from the trough to reach the previous peak. Due to the mathematics of percentage changes, the recovery percentage is always larger than the drawdown percentage. A 10% drawdown needs an 11.1% gain to recover. A 20% drawdown needs 25%. A 33% drawdown needs 50%. A 50% drawdown needs 100%. And a 75% drawdown requires a 300% gain just to get back to breakeven. This asymmetry illustrates why protecting against large drawdowns is so important for long-term portfolio growth.
Drawdown helps set realistic expectations and position sizes for your trading strategy. By understanding the historical maximum drawdown of a strategy, you can determine appropriate leverage levels, allocate capital across multiple strategies, and set circuit-breaker rules for when to reduce exposure. Many professional traders and fund managers use drawdown thresholds as risk limits. For example, they may halve their position sizes after a 15% drawdown, or stop trading entirely after a 25% drawdown for reassessment. Drawdown analysis also helps with portfolio construction by combining uncorrelated strategies to reduce overall drawdowns.
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