# Understanding Maximum Drawdown (MDD): Key Insights and Formula

![Maximum Drawdown (MDD)](https://www.investopedia.com/thmb/_NdlZ2VvMUHXyeh6W0OflflPLOQ=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/maximum-drawdown-mdd.asp-final-861d51b7ffa2482ab4d5e9c0a0e39cc5.png)

*— Investopedia / Mira Norian*

> **Definition**
>
> A maximum drawdown (MDD) represents the largest observed decline in the value of an investment from its peak to its subsequent lowest point, before a new peak is attained.

## What Is a Maximum Drawdown (MDD)?

Maximum drawdown is the worst dip an investment takes from a high to a low. Maximum drawdown indicates downside risk over a given time and shows potential stock volatility. It can be used alone or as part of other measures like "[Return over Maximum Drawdown](https://www.investopedia.com/terms/r/return-over-maximum-drawdown-romad.asp)" and the [Calmar Ratio](https://www.investopedia.com/terms/c/calmarratio.asp).

### Key Takeaways

*   Maximum drawdown (MDD) measures the most severe decline in the value of an investment, highlighting its downside risk and potential volatility.  
    
*   While MDD is an essential tool for understanding an investment's risk, it does not consider the frequency of losses or the duration needed to recover from a downturn.  
    
*   The MDD formula compares the peak value of an investment to its trough value, expressed as a percentage loss from the peak.  
    
*   A lower MDD is preferable, indicating smaller historical losses, whereas a 100% drawdown suggests an investment has become worthless.  
    
*   MDD is particularly useful for comparing stock screening strategies and assessing capital preservation, a critical focus for investors.

## Calculating Maximum Drawdown: The Formula Explained

﻿ $\begin{aligned} MDD=\frac{\textit{Trough Value}-\textit{Peak Value}}{\textit{Peak Value}}\end{aligned}$﻿

## Deeper Insights into Maximum Drawdown

Maximum drawdown is a specific measure of [drawdown](https://www.investopedia.com/terms/d/drawdown.asp) that looks for the greatest movement from a high point to a low point, before a new peak is achieved. It's important to note MDD only measures the largest loss size, not how often losses occur. MDD doesn't show how long recovery from the largest loss takes or if recovery happens.

Maximum drawdown (MDD) helps compare the riskiness of [stock screening](https://www.investopedia.com/terms/s/stockscreener.asp) strategies, focusing on [capital preservation](https://www.investopedia.com/terms/p/preservationofcapital.asp), a key investor concern.

For example, two screening strategies can have the same average outperformance, tracking error, and volatility, but their maximum drawdowns compared to the benchmark can be very different.

A low MDD is preferred as it shows small investment losses. If an investment never loses money, its maximum drawdown is zero. The worst MDD is -100%, meaning the investment becomes worthless.

MDD should be used in the right perspective to derive the maximum benefit from it. In this regard, particular attention should be paid to the time period being considered. For instance, a hypothetical long-only U.S. fund Gamma has been in existence since 2000 and had a maximum drawdown of -30% in the period ending 2010. While this may seem like a huge loss, note that the S&P 500 had plunged more than 55% from its peak in October 2007 to its trough in March 2009. While other metrics would need to be considered to assess Gamma fund's overall performance, from the viewpoint of MDD, it has outperformed its benchmark by a huge margin.

## Illustrating Maximum Drawdown with a Real-World Example

Consider an example to understand the concept of maximum drawdown. Assume an investment portfolio has an initial value of $500,000. The portfolio increases to $750,000 over a period of time, before plunging to $400,000 in a ferocious bear market. It then rebounds to $600,000, before dropping again to $350,000. Subsequently, it more than doubles to $800,000. What is the maximum drawdown?

﻿ $\begin{aligned}&\text{The maximum drawdown in this case is}\\&\qquad\quad=\frac{\$350,000-750,000}{\$750,000=-53.33\%}\end{aligned}$﻿

Note the following points:

*   The initial peak of $750,000 is used in the MDD calculation. The interim peak of $600,000 is not used, since it does not represent a new high.
*   The new peak of $800,000 is also not used since the original drawdown began from the $750,000 peak.
*   The MDD calculation takes into consideration the lowest portfolio value ($350,000 in this case) before a new peak is made, and not just the first drop to $400,000.