Understanding Maximum Drawdown and Using It for Asset Allocation
Maximum drawdown (MDD) measures the largest loss from peak to subsequent trough — the metric that matters more in practice for buy-and-hold investors than volatility. It’s not daily fluctuation that ends investing careers, but the moment a portfolio sits 50% under water and nerves give out.
If you know the historical MDD of your allocation, you can answer the decisive question: can I actually sit through this?
Historical Drawdowns: What Equity Markets Can Really Lose
Calculation: MDD = (trough − peak) / peak. A portfolio falling from €100,000 to €45,000 has a 55% drawdown — and needs +122% from the trough just to get back to even. This asymmetry is the core of the metric: losses weigh geometrically heavier than gains.
The big reference points of recent decades:
| Crisis | Drawdown (world equities, approx.) | Recovery time (approx.) |
|---|---|---|
| Dot-com crash 2000–2003 | around −55% | approx. 6–7 years |
| Financial crisis 2008/09 | around −55% | approx. 5–6 years |
| Covid crash 2020 | around −34% | under 1 year |
| Rate/inflation year 2022 | around −25% | approx. 1–2 years |
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MDD as an Allocation Criterion: Tolerability Before Return
The practical application inverts the usual logic: instead of asking “how much return do I want?”, you ask “how much loss can I withstand without selling?” As a rule of thumb, the bond/cash share reduces drawdown roughly proportionally: a 100% equity portfolio has historically had to budget for around −55%, a 60/40 portfolio for roughly −30 to −35%, a 40/60 portfolio for around −20 to −25%.
Concretely: with a €200,000 portfolio, a 100% equity allocation means staring at roughly €90,000 in a severe bear market — for years. If that thought keeps you up at night, you’ve found your allocation answer before the market forces it.
Two caveats belong to honest use: the historical MDD is not a floor — the future can cut deeper. And as a standalone metric it is blind to the return side; that’s why it belongs alongside relative measures like the Sharpe ratio and loss-probability measures like value at risk.
Frequently asked questions
What is a good maximum drawdown?
It depends on the asset class. World equity portfolios have historically had to budget for drawdowns around −50 to −55%, mixed 60/40 portfolios for around −30%. A drawdown is “good” when you can demonstrably sit through it without selling.
How do I calculate maximum drawdown?
MDD = (trough − previous peak) / peak. Over a time series, take the largest percentage gap between a peak and the subsequent trough.
Why is drawdown more important than volatility?
Volatility also penalises upside moves and describes average behaviour. Drawdown shows the concrete worst-case experience — exactly the situation in which investors typically make mistakes.
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