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Maximum Drawdown

OVERVIEW

Maximum drawdown (MDD) is the largest peak-to-trough decline in a portfolio's value over a specified period, expressed as a percentage of the peak. It measures the worst loss an investor would have suffered if they bought at the highest point and sold at the lowest subsequent point. MDD is the canonical measure of downside risk used by hedge funds, allocators, prop firms, and risk managers — because, unlike volatility, it captures the actual capital pain a strategy inflicts on the people running it.

HOW MAXIMUM DRAWDOWN IS CALCULATED

The formula is direct:

MDD = (Trough Value − Peak Value) / Peak Value

Constraints:

  1. The peak must precede the trough chronologically
  2. The trough is the lowest value reached before a new peak is established
  3. MDD is always expressed as a negative number or absolute percentage
  4. A new high resets the calculation — subsequent drawdowns are measured from the new peak

For a daily equity curve E(t), the running peak at time t is P(t) = max(E(0..t)), the drawdown at time t is D(t) = (E(t) − P(t)) / P(t), and MDD over the period is min(D(t)).

Metric Formula Notes
Calmar Ratio CAGR / \|MDD\| Risk-adjusted return using MDD as denominator
MAR Ratio CAGR / \|MDD\| Same as Calmar; named for Managed Accounts Reports
Recovery Time Periods from trough back to prior peak Captures duration of underwater exposure

WORKED EXAMPLE

An SPY buy-and-hold portfolio peaked at $479 in early January 2022 and bottomed at $349 in October 2022. MDD = (349 − 479) / 479 = −27.1%. SPY did not reclaim its 2022 peak until February 2024 — a 25-month underwater period.

A 60/40 SPY/TLT portfolio during the same window peaked at $385 in January 2022 and troughed at $304 in October 2022. MDD = (304 − 385) / 385 = −21.0%. Same period, lower MDD, but the 60/40 also had a much slower recovery because long-duration bonds remained pinned.

By contrast, an all-cash BIL position over 2022 had MDD near 0% — earning a measly 1.5% but suffering no meaningful drawdown.

WHEN TRADERS USE MAXIMUM DRAWDOWN

MDD is used across the risk-management stack:

Use Case Description
Strategy backtesting Required alongside CAGR and Sharpe; a 30% CAGR strategy with 60% MDD is unrunnable in practice
Position sizing Kelly-style sizing is often capped by MDD tolerance: "I can stomach 25%, so size accordingly"
Allocator due diligence Hedge funds report rolling 3-year MDD in pitch decks
Stop-out rules Prop firms set hard MDD limits (e.g., 5% peak-to-trough = account closure)
Personal risk tolerance The honest question every investor should ask before deploying capital

LIMITATIONS AND COMMON MISCONCEPTIONS

Note

Historical MDD does not bound future losses. Black swan events regularly deliver worse outcomes than any prior sample period.

Limitation Description
Backward-looking Past MDD cannot cap future losses
Path-dependent Small changes to the sample window can materially shift the reported MDD
Frequency-blind A strategy with one 30% drawdown and one with five 30% drawdowns score the same on MDD
Duration-blind A 20% MDD recovering in 3 months differs greatly from one recovering in 5 years
Sample-size sensitive Short backtests underestimate MDD; 10+ years including a recession is the minimum credible sample

Tip

Never compare MDDs across strategies with different sample windows. A strategy backtested 2015–2019 (no major bear market) will show a misleadingly small MDD versus one tested through 2008 or 2020.