All about Maximum Drawdown (MDD)

Drawdown is a decrease in value from peak to bottom in a investment portfolio or fund. Drawdowns are usually expressed as percentages of the drawdown between the peak and its subsequent low. In technical analysis, the term MDD is frequently used. This causes newcomers to ask "What does MDD mean?" MDD stands for maximum drawdown. Portfolio management falls under its purview. What does MDD mean?

What is Maximum Drawdown (MDD), and how can it be used?

Maximum drawdown (MDD), also known as max drawdown, is the largest loss that can be observed when funds are measured from their peak at their trough before a new peak forms. Maximum drawdown is an indicator that measures the downside risk over a period of time. Maximum drawdown can be used as an indicator on its own or in conjunction with other metrics such as the "Calmara Ratio", and "Return Over Maximum Drawdown." It's expressed as a percentage.

Formula for maximum drawdown

Let's look at the max drawing down formula below to better illustrate the meaning.

MDD = Trough Value -- Peak Value / Peak Value

There are many types of drawdown measures. Maximum drawdown considers the greatest amount of movement from a high place in a portfolio, to a low position in it before reaching a new height. It is important to remember that the max drawdown formula only measures the portfolio's greatest loss. Maximal drawdown takes into account how frequently portfolios experience large losses. Max drawdown does not measure the amount of investment that was lost. It only measures the maximum drawdown.

Understanding the purpose and limitations of MDD

MDD is a technical indicator use with the purpose of determining how risky a stock screening strategy would be in comparison to another. Maximal drawdown is a tool that helps to preserve capital and can be used in conjunction with the above goal. As it correlates to the portfolio's ability to earn better returns, capital preservation is a major concern for investors. Let's say that stock screening strategies all have the same tracking error, average performance, and volatility.

Even though this is the case, the maximum drawdown can look very different from the benchmark for these strategies. Low max drawdowns are preferred because they indicate that losses from investments are minimal. A maximum drawdown of 0% would mean that an investment never lost a rupee. Alternately, the maximum drawdown is -100%. This indicates that the investment was worthless.

To get the most out of MDD, it is crucial to have the right perspective. It is important to consider the time frame that is being considered. A fund that was supposed to have been established in 2000 had a maximum drawdown limit of -30% at the close of 2010. This may seem like a big loss, but the S&P 500 plunged more than 55% since its peak in October 2007 and its lowest point in March 2009. While other metrics are important to evaluate the fund's overall performance. MDD makes it clear that the fund outperformed its benchmark index by an enormous margin.

Maximum Drawdown Example

Here's an example of how the max drawdown formula can be used: Let's say that an investment portfolio had an initial value Rs5 lakhs. The portfolio's value rises to Rs7.5 lakhs over time. However, it plummets back to Rs4 lakhs during a very brutal bear market. The value rebounded to Rs6 lakhs, but then it dropped back to Rs3.5 lakhs. The value then jumps by more than two-fold to Rs8 lakhs. How much can you draw down this portfolio?

We will use the information to determine the maximum drawdown. The portfolio's initial peak value is Rs7.5 lakhs and its lowest position is Rs3.5 lakhs. The maximum drawdown in this example is:

MDD = (3.50,000 - 7,50,000)/ 7,50,000 = 53.33%

These are some of the things you should be aware of:

The initial peak of Rs7.5 millions will be used to calculate max drawdown. Since this value is not a new MDD peak, the peak of Rs65,000s between the initial and final high positions will be ignored.

- The maximum drawdown calculation will not include the latest peak of Rs8 Lakhs. This is because the original drawdown should only consider the first peak.

- MDD is calculated by cherry-picking the lowest value among all. This will not be the case for the peak value. This value, Rs3.5 lakhs in the above example, will be used to calculate MDD. It was the first drop that occurred right before the new peak formed. This value cannot be used to determine the maximum dropdown, even though the initial drop was Rs4 lakhs.

Conclusion

The portfolio's MDD is a key technical tool that allows for analysis of its performance. Investors can determine the best way to allocate funds and maximize earnings by looking at their MDD.