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When we create a portfolio of investments, our primary aim is to maximize returns while taking the minimum risk possible (or we can say maximum risk-adjusted returns). With age, our financial plan also changes. For example, a young investor with a predictable monthly income will be able to take more risks for better long-term gains. At the same time, a retired citizen with limited income will aim to preserve his/her portfolio and won’t invest in risky assets.
Many investors are also concerned about only downside risk as they want to protect their investments and limit the downside risks. They don’t prefer to invest money in assets that fall more during downtime, even though the same assets will provide better returns in the long term.
To analyze the investment’s downside, we use maximum drawdown.
Maximum drawdown (MDD) is the maximum loss observed between a peak and trough of a portfolio before a new peak is reached. We can understand this by looking at the below chart.
Let's calculate it to understand it even better. We have rounded off the numbers for easy understanding. Before the COVID downfall, the Nifty had risen to the level of almost 12500. After that, the price started falling and make a low of almost 7500. Maximum drawdown can be calculated as
Maximum Drawdown (MDD) = (Through value - Peak value) / Peak Value
= 7500 - 1250012500
= -40%
Risk-averse investors who are more focused on the downside risks prefer to invest assets that have low MDD. This indicator can help you measure the downside risk in the worst cases (like the COVID crash). Investors can use this parameter as a screening criterion for their portfolio. You can find more about it here.
You can also find MDD on any mutual fund in the overview section of the fund in Sharpely as shown below.
Yes, maximum drawdown is important. This is because, after any percentage fall in the asset price, recovery will demand an even higher percentage of increase. For example, if a stock price falls from Rs. 100 to Rs. 50, then the price fall is 50%. But to go back to the high of Rs. 100 from the low of 50, the stock has to move up by 100%. MDD also impacts the long-term CAGR of the portfolio.
Investors can use maximum drawdown to evaluate the risk of an investment or portfolio. Additionally, it can be used to compare different investment options and determine which one has a lower downside risk.
