What is "Maximum Drawdown"?

Maximum Drawdown is one way to measure the riskiness of a mechanical investment program.

Compared with other risk statistics, Maximum Drawdown is particularly easy to interpret and apply to your own situation.

• It is expressed as a percentage – such as 4.5% or 17.8%.

You can apply the percentage directly to the size of your own portfolio and get an estimate of how much money you could lose at some intermediate point in time during the life of the investment strategy.

How do we measure Maximum Drawdown? Look at the chart below. It shows the historical results of two alternative investment strategies:

• In this case we compare a traditional Buy and Hold strategy invested in the S&P 500 Index with one of our mechanical strategies, the Growth Portfolio.

Figure I charts the growth of a hypothetical $10,000 investment account over a six year period of time. For each strategy, the colored line plots the increase, or decrease, of the original $10,000 investment over time.

Figure I

 

“Drawdown” simply measures any decreases in the colored line – or investment balance – from any "peak to valley".

• Drawdown represents the total percentage loss experienced by a strategy before it starts winning again ... and drives the investment balance back up.

“Maximum Drawdown” is simply the largest drawdown experienced by a strategy during the period of time under study.

How to relate maximum drawdown statistics to your “Risk Tolerance”?

Do you know your risk tolerance? Can you express it in terms of a percentage?

• Let’s say that you are willing to experience portfolio losses of as much as 10% of the total investment in order to have the chance to earn higher stock market returns (rather than keep the money completely safe in a bank account.) If so, then you can express your risk tolerance as a percentage – 10%.

Knowing this, you would want to choose an investment strategy that has a Maximum Drawdown statistic of 10% or less. If you chose a strategy with a 15% Maximum Drawdown, it would be too risky for your expressed risk tolerance.

It’s quite straightforward ... especially compared to the other measures of risk you may see. That’s exactly why we like to use it.

Compare the riskiness of different investment strategies.

One caution about this statistic ... It’s backward looking, like any statistic; and its accuracy is certainly dependent upon the length of time studied to compute the statistic. As a result, Maximum Drawdown can’t tell you exactly what will happen in the future because market dynamics can change.

• However, Maximum Drawdown is an excellent way to compare the inherent riskiness of different strategies.

Trading professionals use the statistic extensively.

Therefore, if you calculate your risk tolerance as 10%, you will likely be better off using a strategy with an 8% Maximum Drawdown (less than 10%) than an alternative with a 15% statistic (more than 10%).