Drawdown measures risk by the amount of money you have lost since your account reached its highest level. If your account went straight up without losing a single penny, then by this measure, you didn’t incur any risk. It’s a very direct way of measuring risk, because at the end of the day, it’s by losing money that you’ll feel vulnerable, that you’ll feel the pain, that you’ll feel fear, that you’ll feel the lost, and what makes you finally say “I have enough!” and abandon your investment or strategy.
We prefer to use it over more traditional measure like Standard Deviation, because it’s more practical.
Drawdowns can be measured in either monetary (e.g., dollar) or percentage terms. The former is useful when comparing strategies that use fixed amount of units (e.g., 100 shares or 1 contract), while the latter is more appropriate for general use.
If your account started at $10,000, and assuming you lost ground from the get go and it is now worth $8,000, then your current drawdown would be $2,000 or (20%). Let’s say your account makes $3,000 over the next several weeks, and it’s now worth $11,000 – the highest ever recorded in your account – then your drawdown goes back to zero. Finally, let’s say you lose $1,000 the next day so your account is now back to where it started, then your drawdown is $1,000 or (9.1%). Why? Because we’re now comparing your current account balance to $11,000 (the highest value) instead of $10,000.
Maximum drawdown (MaxDD), as its name implies, is the largest drawdown ever recorded in your account. It measures the largest amount of money – in absolute and percentage terms – you would have lost from an equity peak to an equity trough. Another way to look at it is the maximum money you would have lost had you invest in a fund at the worst possible time, and abandoned it at the worst possible time.
A MaxDD of zero means your account never lost a single penny; a MaxDD of (50%) percent means that at some point, your account lost half of its value; and a MaxDD of (100%) means you’re wiped out. As a side note, a lot of hedge funds “blow up” when they reach a predefined MaxDD threshold like 50%, and this triggers them to return all the investor’s money (or whatever is left of it).
As you can tell, it is a very practical, although very pessimistic, measure of risk, and this is one of our favorite performance measures when comparing strategies. One look at the maximum drawdown and you’ll get an idea how much risk, pain, and suffering you need to go through in order to reap the promised rewards of a particular strategy or investment.
Every performance indicator has a blind side, and the biggest criticism for maximum drawdown is that it penalizes a fund or strategy for a one-time event that happened in the past. That’s like doing something bad when you were a teenager and being branded for what do did for the rest of your life.
The solution? One way is to take the average of the top n biggest drawdowns. Another way is to enumerate the top n biggest drawdowns and when they occurred. It’s no longer a single convenient number, but at least if gives you a better context.