A drawdown is the decline in an asset or account from a previous peak to a later trough. Maximum drawdown is the deepest peak-to-trough loss observed over a chosen period. It tells you how far your capital fell before recovering or setting a new low.
How it works
If an account falls from $100,000 to $80,000, the drawdown is 20%. Recovering from $80,000 back to $100,000 requires a 25% gain. A 50% drawdown requires a 100% gain to return to the original peak.
Drawdown changes as new highs and lows are made. A year-end return can hide a painful path in between, so strategy analysis often compares returns with maximum drawdown rather than looking at final performance alone.
Why it matters
Drawdown directly affects compounding. The deeper the loss, the faster the required recovery return rises, which is why risk control focuses on avoiding catastrophic declines rather than avoiding every small loss.
It also changes behavior. Long losing stretches can push traders to increase size, abandon rules, or trade more often in an attempt to get back to even, creating a second layer of risk on top of the market loss.
A simple market example
The Federal Reserve's July 2026 Monetary Policy Report describes a useful recent example in U.S. equities. Broad stock prices fell sharply from late January through late March as AI concerns and the Middle East conflict hit sentiment, while the VIX rose to around 30 in late March. Stocks later recovered and reached new record highs. That path is exactly why drawdown is different from permanent loss: an investor could have experienced a significant peak-to-trough decline even though the broad market eventually recovered. The risk question is whether the portfolio could survive that path without forced selling or rule-breaking.
Common mistakes
Treating drawdown as the same thing as a realized permanent loss. Drawdown describes the path from a peak to a trough; recovery may or may not follow.
Comparing strategies only by final return. Two portfolios can both finish up 10% while one experienced an 8% drawdown and the other fell 40% along the way.
Frequently asked questions
How do you calculate maximum drawdown?
Track each running peak, measure the decline to subsequent lows, and take the deepest percentage drop over the period.
Why does a 20% drawdown need a 25% gain to recover?
Because the gain is calculated from the smaller remaining capital base: 80 must rise 25% to return to 100.
Is the strategy with the smallest drawdown always best?
No. Returns, time horizon, turnover, and objectives also matter, but deep drawdowns usually create greater capital and behavioral stress.
Educational content only. Definitions describe common market usage and may vary by jurisdiction, instrument, or institution.