How is maximum drawdown calculated, and why do risk managers use it alongside VaR?

Question

AcadiFi · Accepted Answer

**Maximum drawdown (MDD)** measures the largest cumulative loss from a peak to a subsequent trough before a new peak is established. It captures the worst-case experience an investor would have endured by holding through the most painful period.

**Formula**

**MDD = (Trough Value - Peak Value) / Peak Value**

You compute this over a running maximum of the portfolio value series and find the deepest valley.

**Step-by-Step Calculation**

Consider Prescott Capital's monthly portfolio values over 12 months:

| Month | Value ($M) | Running Peak ($M) | Drawdown |
|---|---|---|---|
| Jan | 100.0 | 100.0 | 0.00% |
| Feb | 104.2 | 104.2 | 0.00% |
| Mar | 101.8 | 104.2 | -2.30% |
| Apr | 97.5 | 104.2 | -6.43% |
| May | 93.1 | 104.2 | **-10.65%** |
| Jun | 96.4 | 104.2 | -7.49% |
| Jul | 99.8 | 104.2 | -4.22% |
| Aug | 105.1 | 105.1 | 0.00% |
| Sep | 103.6 | 105.1 | -1.43% |
| Oct | 108.3 | 108.3 | 0.00% |
| Nov | 107.0 | 108.3 | -1.20% |
| Dec | 112.5 | 112.5 | 0.00% |

**Maximum Drawdown = -10.65%** (peak of $104.2M in Feb to trough of $93.1M in May).

The **drawdown duration** was 6 months (Feb peak to Aug recovery).

```mermaid
flowchart LR
    A["Feb Peak: $104.2M"] --> B["Decline begins"]
    B --> C["May Trough: $93.1M"]
    C --> D["Recovery phase"]
    D --> E["Aug: New peak $105.1M"]
    style C fill:#ef4444,color:#fff
    style A fill:#10b981,color:#fff
    style E fill:#10b981,color:#fff
```

**Why MDD Complements VaR**

| Metric | Measures | Time Horizon | Path Dependent? |
|---|---|---|---|
| VaR | Loss at a single confidence level | Single period (1-day, 10-day) | No |
| MDD | Worst cumulative loss experienced | Entire sample path | **Yes** |

VaR tells you "on a bad day, you might lose X" — but it says nothing about sequences of bad days. An investor who sees five consecutive losing months may redeem regardless of whether any single day exceeded the VaR limit. MDD captures this behavioral and operational reality.

**Practical Uses:**
- Hedge fund due diligence (investors often have MDD thresholds like "no allocation if MDD > 20%")
- Strategy comparison — two strategies with the same Sharpe ratio may have very different drawdown profiles
- Risk limit setting — combining VaR limits with drawdown stop-loss triggers

For more risk measurement techniques, check our FRM Part I materials.

How is maximum drawdown calculated, and why do risk managers use it alongside VaR?

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