What Is Maximum Drawdown?
Maximum drawdown (MDD) is the largest peak-to-trough decline in a portfolio's value over its entire history. If a portfolio peaked at $100,000, dropped to $60,000, recovered to $120,000, then dropped to $90,000, the MDD is 40% (from $100K to $60K). MDD captures the absolute worst loss experience during the entire period.
How Maximum Drawdown Works
MDD is the most emotionally impactful risk metric because it represents the worst pain point you experienced. A strategy showing 200% total returns with a 60% MDD means you experienced a 60% portfolio decline at some point — could you handle that psychologically? The recovery time (how long it takes to return to the previous peak after the drawdown) is equally important.
Why It Matters for Traders
When evaluating any strategy or fund, MDD should be a primary consideration alongside returns. A strategy returning 50% with 20% MDD is superior to one returning 80% with 60% MDD because the risk-adjusted return is better and the survival probability is higher. In live trading, expect your MDD to exceed backtest MDD by 50-100% due to execution realities and market conditions that weren't in the test period.