Maximum drawdown refers to the largest cumulative loss of a portfolio within a given time interval. While it has been used by investment professionals as an important measure of portfolio risk for many years, its nature and its implications for asset pricing have not been well understood. The first part of the paper presents a rigorous argument for using maximum drawdown as a portfolio risk measure. The argument is based on liquidity preference of Keynes and rank dependent utility of Quiggin. We extend the Markowitz portfolio problem by including expected maximum drawdown as the third argument of the objective function. The second part of the paper investigates asset pricing implications. The marginal contribution of an individual asset to portfolio maximum drawdown—we call this “co-drawdown”—plays an important role. In an extended CAPM, there exists a linear relationship between expected return and co-drawdown.
Keywords: Maximum drawdown, Rank dependent utility, Markowitz portfolio problem, Co-drawdown, CAPM
JEL Classification: G11, G12, D81
