Risk as a Survival Variable

December 8, 2014
By

(This article was first published on The R Trader R, and kindly contributed to R-bloggers)

I come across a lot of strategies on the blogosphere some are interestingsome are a complete waste of timebut most share a common feature: people developing those strategies do their homework in term of analyzing the return but much less attention is paid to the risk side its random nature. I’ve seen comment like “a 25% drawdown in 2011 but excellent return overall”. Well my bet is that no one on earth will let you experience a 25% loss with their money (unless special agreements are in place). In the hedge fund world people have very low tolerance for drawdown. Generally, as a new trader in a hedge fund, assuming that you come with no reputation, you have very little time to prove yourself. You should make money from day 1 and keep on doing so for a few months before you gain a bit of credibility.

Firstlet’s say you have a bad start and you lose money at the beginning. With a 10% drawdown you’re most certainly out but even with a5% drawdown the chances of seeing your allocation reducedare very high. This has significantimplicationson your strategies. Let’s assume that if you lose 5% your allocation is divided by2and you come back to your initial allocation only when you passed the high water mark again (e.g. the drawdown comes back to 0). In the chart below I simulated the experiment with one of my strategies.

chart2

You start trading in 1st June 2003 and all goes well until 23rd Jul. 2003 where your drawdown curve hits the -5% threshold (**1**). Your allocation is cut by 50% and you don’t cross back the high water mark level until 05thDec. 2003 (**3**). If you have kept the allocation unchanged, the high water mark level would have been crossed on 28th Oct.2003 (**2**) and by the end of the year you would have made more money.

But let’s push the reasoning a bit further. Still on the chart above, assume you get really unlucky and you start trading toward mid-June 2003. You hit the 10% drawdown limit by the beginning of August and you’re most likely out of the game. You would have started in early August your allocation would not have been cut at all and you end up doing a good year in only 4 full months of trading. In those two examples nothing has changed but your starting date….

Thetrading success of any individual has some form of path dependency and there is not much you can do about it. However you can control the size of a strategy’s drawdown and this should be addressed with great care.Aportfolio should be diversifiedin every possible dimension: asset classes, investment strategies, trading frequencies etc…. From that perspective risk is your “survival variable”.If managed properly you have a chance to stay in the game long enough to realise the potential of your strategy. Otherwise you won’t be there next month to see what happens.

As usual any comments welcome

To leave a comment for the author, please follow the link and comment on their blog: The R Trader R.

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