Maximum drawdown offers investors a worst case scenario. Maximum drawdown tells the investor how much would have been lost if an investor bought at the absolute peak value of an investment, rode it all the way down, and sold at rock-bottom.
One would hope that the maximum drawdown would be as small as possible. If an investment never lost a penny, the maximum drawdown would be zero. The worst possible maximum drawdown would be 100%, meaning the investment is completely worthless. Most maximum drawdowns will fall somewhere between these two extremes. The two most important elements to keep in mind when analyzing maximum drawdown are the asset class and time frame being analyzed.
Maximum drawdown only measures one dimension of capital preservation. It does not tell us how long it took to recover from the loss, or if the investment even recovered at all. Maximum drawdown does not tell us if other losses were short and sharp or long and drawn-out. Maximum drawdown measures only the largest drawdown. Other smaller periods of loss are ignored. For these reasons Zephyr recommends the pain index as a more complete measure of the depth, duration, and frequency of losses.
The below graph is a simple cumulative return chart showing how the value of $100 would have fluctuated over time. The red arrow represents the maximum drawdown. It shows, in percentage terms, how much wealth was lost from peak-to-trough of the worst decline. Note that smaller peak-to-trough losses are not quantified.
The maximum drawdown calculation depends heavily upon the time frame under examination. In this example, we examine the period from January 1986 to December 2012. For many asset classes, the worst period fell between late 2007 and early 2009 during the Credit Crisis. Many equity asset classes lost over half of their value. It took over two years for most equity asset classes to recover, but as of December 2012 International Stocks have yet to fully recoup their losses.
The calculation of maximum drawdown looks at all subperiods of the time period in question and calculates the compound return of the manager over each subperiod. The maximum drawdown is the lowest value of all these compound returns.
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