Maximum drawdown investment risk management

What is MDD?

MDD, or Maximum Drawdown, is a measure of the maximum percentage decline of an asset or portfolio from its peak to its trough over a specific period. It represents the theoretical maximum loss one could face if they were to buy at the peak and sell at the trough, providing a clear reflection of investment risk.

The Importance of MDD

Whether in traditional financial markets or in the Web 3 investment space, MDD plays a key role:

• Clearly present the maximum loss to help investors understand the potential risks.
• It is an important indicator for testing the robustness of quantitative backtesting strategies against volatility.
• Provide quantitative references for psychological and financial pressures to help investors assess their risk tolerance.
• Helps determine whether to adjust leverage and investment allocation, reducing excessive risk.

Balance of Reward and Risk

High returns are usually accompanied by high risks, and it is easy to overlook the significant drawdown risk behind the returns, for example:

• Strategy A: Annualized return rate of 20%, MDD 15%
• Strategy B: Annualized return rate 40%, MDD 50%

Although Strategy B offers higher rewards, the MDD of up to 50% indicates that assets may shrink rapidly, bringing heavy pressure.

Methods to Reduce MDD

Controlling maximum drawdown is the core of Risk Management, common practices include:

• Diversification of assets reduces the impact of fluctuations in a single market.
• Reduce leverage to avoid magnifying losses.
• Set stop-loss points to promptly limit losses and avoid further losses.
• Dynamically adjust positions and modify the position size based on market fluctuations.
• Use derivatives for hedging, such as options, futures, and other tools to mitigate risk.

Limitations of MDD

MDD reflects the maximum loss in the past, but it has its shortcomings:

• Focusing only on the historical largest drop, ignoring fluctuations during other periods.
• No predictive power, past performance does not guarantee future results.
• The response speed is not covered, which means the asset recovery time after the drawdown ends.

Therefore, it is recommended to assess risk in conjunction with other indicators such as volatility, Sharpe ratio, etc.

Summary

MDD is the cornerstone of investment risk control, quantifying the maximum possible loss to help investors maintain rational judgment in a volatile market. Mastering MDD not only prevents significant capital losses but also allows you to move steadily in both traditional and Web 3 markets.