Capital preservation and steady performance are important considerations in investing. Therefore, this makes the maximum drawdown formula highly relevant.
Maximum drawdown is defined as the peak-to-trough decline of an investment during a specific period. It is usually quoted as a percentage of the peak value. The maximum drawdown can be calculated based on absolute returns, in order to identify strategies that suffer less during market downturns, such as low-volatility strategies. However, the maximum drawdown can also be calculated based on returns relative to a benchmark index, for identifying strategies that show steady outperformance over time.
For example: two strategies can have the same average outperformance, tracking error, information ratio and volatility, but their maximum drawdowns compared to the benchmark can be very different.
For instance, suppose that the first one achieves a monthly performance of 1%, -0.5%, 1%, -0.5% and so on versus the benchmark, while the second strategy achieve an outperformance of 1% each month during the first half of the sample, but an underperformance of 0.5% each month during the second half of the sample. Most investors would strongly prefer the first strategy, because it has a much lower maximum drawdown than the second strategy! Furthermore, the length of the drawdown period is shorter.
We use maximum drawdown as one of the key statistics for evaluating our quantitative investment strategies and for deciding on the introduction of new variables in our models.
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