Maximum Drawdown (MDD): Meaning, Formula, and Importance

Often, investors look at performance charts, past returns* and volatility indicators to evaluate how an investment might perform over time. However, there are several other metrics available today to help investors make more informed decisions about their investments. One such metric, which can help understand the downside risk of an investment, is called Maximum Drawdown (MDD).

Maximum drawdown helps investors project the maximum fall in the value of an investment before it potentially recovers. In this article, we will look at the concept of Maximum Drawdown, its formula, purpose and some examples.

*Past performance may or may not be sustained in future.

Table of contents

• What is maximum drawdown (MDD)?
• Max drawdown formula
• Understanding the purpose of MDD
• Maximum drawdown example

What is maximum drawdown (MDD)?

To help investors assess risk, Maximum Drawdown (MDD) is a metric that showcases the biggest potential fall an investment can experience from its highest point to its lowest point. Using data from a specific period, it highlights the maximum percentage loss that could have occurred if you had invested at the highest point and held through the lowest point before the recovery.

The MDD formula compares the investment’s highest value (peak) to its lowest value (trough) and expresses the drop as a percentage. A smaller MDD means the investment has faced smaller losses in the past. On the other hand, a 100% drawdown means the investment lost all its value at some point.

In this way, MDD helps investors estimate the downside risk of an investment. However, it doesn’t show how often losses occur or how long it may take for the investment to potentially recover. Investors may use MDD to compare different investment strategies and evaluate them. They must, however, note that MDD does not predict future losses and only showcases what has happened historically. Thus, it is advisable to calculate the MDD over different market conditions and multiple cycles, rather than looking at just 1-year returns.

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Max drawdown formula

The formula for calculating Maximum Drawdown (MDD) is as follows:

Maximum drawdown (MDD) = [(Trough value – Peak value) / Peak value] x 100

Here, Peak Value refers to the highest point of the investment’s value before a decline and Trough Value is the lowest point reached after the peak before recovery begins. To convert the output into a percentage, multiply the resulting figure by 100.

Let’s understand this with an example.

Suppose a portfolio’s value peaks at Rs 1,00,000 and then drops to Rs 75,000 before rising again, the Maximum Drawdown would be:

(1,00,000 - 75,000) / 1,00,000 X 100 = 25%

So, the Maximum Drawdown is 25%, meaning the portfolio experienced a 25% decline from its peak before recovering.

Example for illustrative purposes only.

Understanding the purpose of MDD

Measuring downside risk

Market uncertainty is something that every investor faces. Maximum Drawdown tells you how much an investment has declined in the past, helping you gauge the potential downside risk. For instance, two mutual funds may offer similar long-term potential returns, but one might have a lower Maximum Drawdown. The one with the lower MDD, therefore, was comparatively less volatile.

Understanding recovery requirements

Whenever an investment falls in value, it takes a larger percentage gain to recover to the original level. Therefore, Maximum Drawdown helps investors understand how steep a potential recovery path may be required after a downturn.

Risk management tool

Portfolio managers and analysts may use MDD as a tool to track performance consistency. If an investment’s drawdown exceeds a predefined limit, it may prompt a review or rebalancing of the portfolio to manage exposure.

Assessing resilience

Markets go through different cycles of expansion, correction and recovery. Maximum Drawdown indicates how an investment behaved during difficult periods in the market. For long-term investors, a smaller drawdown may indicate that the investment has the potential for relative stability during volatile conditions.

Read Also: Price to Sales Ratio: Meaning, Benefits and Calculation

Maximum drawdown example

Now that we have learnt the nuances of Maximum Drawdown, let’s have a better understanding of it through an example.

Suppose an investor starts with a portfolio worth Rs. 4 lakh. Over time, the portfolio grows to Rs. 6 lakh, but then falls sharply to Rs. 3 lakh during a market crash. Later, it recovers to Rs. 5 lakh, only to drop again to Rs 2.5 lakhs. Eventually, the portfolio bounces back and reaches Rs. 7 lakh. Now, let’s calculate the maximum drawdown.

Here, the first peak value is Rs 6 lakhs, and the lowest point (trough) before a new peak is Rs 2.5 lakhs. Using the MDD formula:

MDD = (2,50,000 – 6,00,000) / 6,00,000 x 100 = 58.33%

This means the portfolio’s maximum drawdown is 58.33%, showing the biggest drop it faced from a high to a low.

A few important points to remember:

• We use the first peak (Rs. 6 lakh) for the calculation because it’s the highest point before the decline began.
• The later peak of Rs. 7 lakh is not used, as MDD is based on the first major high before the largest fall.
• For the trough value, we always pick the lowest value before a new peak forms, so in this case, Rs. 2.5 lakh. Even though the portfolio earlier dropped to Rs. 3 lakh, that wasn’t its lowest point, so it’s not used for MDD.

Example for illustrative purposes only.

Conclusion

The concept of Maximum Drawdown (MDD) helps investors understand the biggest fall an investment has experienced––from its highest point to its lowest point––during a given period. While it doesn’t predict future losses, it helps investors assess whether a portfolio or strategy might align with their risk profile, time horizon and investment goals. Furthermore, it is important to remember that no single metric can fully describe an investment’s performance or risk. However, taken together, multiple metrics may help develop a more informed view.

FAQs

What is the definition of Maximum Drawdown (MDD)?

Maximum Drawdown (MDD) is a measure of the largest percentage drop in the value of an investment from its peak to its lowest point before recovery. It shows how much value was lost during a decline and helps investors assess the extent of potential downside risk.

How is MDD calculated?

Maximum Drawdown (MDD) = [(Trough Value – Peak Value) / Peak Value] x 100

Here, Peak Value refers to the highest point of the investment’s value before a decline and Trough Value is the lowest point reached after the peak before recovery begins.

What does MDD tell an investor about risk in a portfolio?

MDD shows investors how much a portfolio or investment declined in the past during a particular period. A higher MDD indicates that the investment has experienced deeper declines, suggesting relatively higher risk or volatility.

What are the limitations of using MDD as a standalone metric?

It focuses on historical data and does not predict future risks. It also does not measure how often losses occurred or how long it took for the investment to recover in the period under consideration.

How should investors use MDD alongside other performance metrics?

Investors may use maximum drawdown to understand how risky an investment or portfolio may potentially be. It may also help them compare different investment options in terms of downside risk.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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