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What is Return / Drawdown ratio

A good way to evaluate the risk of a portfolio

Return / Drawdown Ratio

Drawdown is a measurement of risk. The higher the drawdown is, the riskier your model is.

We have to distinguish between maximum drawdown and average drawdown.

The former is referred to the maximum loss faced from a peak during the whole period of analysis, while the latter is calculated as an average of the maximum drawdowns year by year (or period by period, it depends what is your landmark, sometimes it cuold be even necessary to alculate it weekly or monthly).

It is important to evaluate your drawdown in relation to the expected return for this model. For example, if I expect 2% drawdown and a 4% of average profit per year, the ratio will be 2 and it means literally speaking that each time you earn 2 dollars, you can expect to lose maximum 1 dollar per year in your average worst case scenario. So it is important to know how much to risk in order to define whether you are going to earn enough to edge such a risk.

Backtesting gives you a framework of what you can expect from reality, despite it is just a proxy. What it is important is to be wide when calculating return on drawdown ratio and consider an interval of confidence in which your model is considered to be valid. In a few words, if you think a ratio of 2 is the minimum acceptable, your model ought to give a result higher than 2, in order to be edged when testing forward.

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