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A maximum drawdown (MDD) is the maximum observed loss from a peak to a trough of a portfolio, before a new peak is attained. Maximum drawdown is an indicator of downside risk over a specified time period, with large MDDs suggesting that down movements could be volatile.

Maximum Drawdown is expressed in percentage terms:

Assume an investment portfolio has an initial value of $500,000. The portfolio increases to $750,000 over a period of time, before plunging to $400,000 in a ferocious bear market. It then rebounds to $600,000, before dropping again to $350,000. Subsequently, it more than doubles to $800,000.

The maximum drawdown in this case is ($350,000-$750,000)/$750,000= −53.33%

Note:

l The initial peak of $750,000 is used in the MDD calculation. The interim peak of $600,000 is not used, since it does not represent a new high. The new peak of $800,000 is also not used since the original drawdown began from the $750,000 peak.

l The MDD calculation takes into consideration the lowest portfolio value ($350,000 in this case) before a new peak is made, and not just the first drop to $400,000.

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