Maximum Drawdown (MDD) is a very important measure of investment risk.  It measures the largest percentage drop in the value of a portfolio from a peak to a subsequent bottom before that portfolio value makes a subsequent new high.  Each peak to bottom drop is called a drawdown, and the MDD is the largest drawdown of them all.

For example, consider a $10,000 portfolio that is invested in 2004.  Let’s say it goes up to a peak of $13,000 in late 2007, and then loses $6,000 during the financial crisis, hitting its lowest point in 2009 at a value of $7,000.  It then recovers to make a new high of $15,000 by 2014.

In the above example, the Maximum Drawdown was $6,000 in dollar terms or, in percentage terms, it was $6,000 / $13,000 = 46%.  In other words, the portfolio lost 46% from peak to valley before starting to recover, and it occurred between 2007 and 2009.

To be a meaningful investment risk measure, MDD should be considered over a fairly long period of time – like at least a decade.  This is to ensure that the portfolio has gone through at least one full economic cycle, and therefore had the opportunity to suffer through at least one major bear market.

Backtesting Strategies & Overfitting

Strategy backtesting is often used to test an investment strategy from historical stock or ETF information (usually price).  The belief is that if a strategy performed well in the past, then it should continue to perform well in the future.

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