Drawdown
The peak-to-trough decline in portfolio value; key risk metric for live and backtest.
Definition
Drawdown at time ( t ) is the decline from the most recent peak: ( DD_t = (Peak_t - P_t) / Peak_t ). Maximum drawdown (MDD) is the largest such decline over the period.
Why it matters
- Volatility does not capture path (two strategies can have same vol but very different drawdowns).
- Investors care about “how much can I lose from a high?”. That’s drawdown.
Common mistakes
- Reporting only Sharpe and ignoring MDD.
- Assuming backtest MDD will not be exceeded live (often is).
- Not defining a “drawdown stop” or action plan before going live.
Best practices
- Report MDD and calmar (return / MDD).
- Stress test with historical crisis periods.
- Have a rule: reduce risk or pause after X% drawdown.