One of the key indicators we display in order to assess the risk of a given stock screening strategy is the maximum drawdown. It measures the largest peak-to-trough decline in the value of a portfolio (before a new peak is achieved).
It is calculated as a percentage as being: Peak value before largest drop - Lowest value before new high established divided by the Peak value before the largest drop.
For example if a portfolio starts being worth £100,000, increases in value to £150,000, decreases to £90,000, increases to £125,000, then decreases to £80,000, then increases to £225,000, the max drawdown is (£150,000- £80,000) / £150,000 = 46.67%. The highest peak of £225,000 is not included in the calculation because the drawdown began at a peak of £150,000. Likewise the increase to £125,000 before the drop to £80,000 is ignored, because £125,000 was not a new peak.
The MDD is a useful way to assess the relative riskiness of one screen versus another, as it focuses on capital preservation, which is a key concern for most investors. However, it's important to remember that it only measures the size of the largest loss, but says nothing about the frequency of large losses. For example, strategy A may have a MDD of -35% and strategy B may have a MDD of -60%, but strategy A may experience multiple -35% drawdowns, whereas strategy B may have experience no drawdowns, apart from the -60% drawdown observed. Which is riskier? It's debatable and depends on your intended hold time period.
For the avoidance of doubt, this relates to the performance of the basket as a whole, it may well be the case that a given single stock within the basket experiences a much higher drawdown but has been hedged by the rest of the basket. It's always important to consider other risk management elements, for example the extent to which the portfolio is diversified.