Using Maximum Drawdown to Set Risk and Capital Targets

Summary

This document examines maximum drawdown as a way to set capital or risk targets. It frames drawdown in relation to annualised volatility, Sharpe ratio, and the length of the measurement period, and compares drawdown-based sizing with Kelly-style risk targeting. The figures described use simulated return series under specified assumptions, including different backtest lengths and a fixed volatility and Sharpe ratio in several comparisons.

A central caution is that an attractive drawdown in a backtest may reflect survivorship or look-ahead bias, overfitting, or a future environment that is less favorable than the past. The document also highlights the wide sampling distribution of estimated maximum drawdowns: a single historical path can give a misleading impression of likely risk. The supplied text identifies the analyses and assumptions but omits plotted values and detailed conclusions, so it does not establish a universal sizing rule.

Key ideas

• Maximum drawdown varies with volatility, Sharpe ratio, and the period observed.
• A single backtest’s worst drawdown is a noisy estimate of future risk.
• Survivorship bias, look-ahead bias, overfitting, and changing market conditions can make historical drawdowns look too small.
• The document compares drawdown-based risk targets with Kelly-based targets using simulated return histories.
• Sizing conclusions depend on the assumed return characteristics and sample length.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.