📉 Max Drawdown
Max Drawdown (MDD) measures the largest peak-to-trough decline in portfolio value before a new peak is established. It answers the question: "What was the worst loss an investor could have experienced?"
🔢 Formula
where \(V_t\) is the portfolio value at time \(t\).
The drawdown at any point \(t\) is:
Max drawdown is the minimum (most negative) value of \(DD_t\) over the entire observation period.
💡 Interpretation
| Max Drawdown | Typical Context |
|---|---|
| \(-5\%\) to \(-10\%\) | Normal correction, well-diversified portfolio |
| \(-10\%\) to \(-20\%\) | Significant correction |
| \(-20\%\) to \(-30\%\) | Bear market territory |
| \(-30\%\) to \(-50\%\) | Severe bear market (2008, COVID-2020) |
| \(> -50\%\) | Catastrophic (concentrated positions, crypto) |
Numerical example
Portfolio value sequence: 100 → 120 → 90 → 110 → 130
- Peak: 120
- Trough: 90
- MDD: \((90 - 120) / 120 = -25\%\)
- Recovery: reached 120 again, then new high at 130
⏱️ Recovery Time
An equally important metric is recovery time — how long it takes to recover from the drawdown and reach a new peak:
| Asset Class | Typical Recovery Time (after major drawdown) |
|---|---|
| US Stocks (S&P 500) | 1-5 years |
| Bonds | Months to 1-2 years |
| Crypto | Highly variable (months to years) |
Asymmetry of losses
A 50% loss requires a 100% gain to recover:
| Loss | Required Gain |
|---|---|
| -10% | +11.1% |
| -25% | +33.3% |
| -50% | +100% |
| -75% | +300% |
📊 Drawdown Chart
A drawdown chart plots \(DD_t\) over time. It's always zero or negative, touching zero at each new peak. The deepest valley is the max drawdown. This visualization makes it easy to:
- Identify the timing of worst-case periods
- See how frequently drawdowns occur
- Compare recovery patterns across different strategies
🔗 Related
- 📊 Volatility — Standard deviation doesn't capture drawdown severity
- 📐 Sharpe Ratio — Risk-adjusted return (uses volatility, not drawdown)
- 🔀 Diversification — The primary tool for reducing max drawdown