The case for Draw-downs

The biggest worry for a Systematic Trader is the Draw-down number. Bigger the number, more he worries about his ability to trade the system since it can be  psychologically difficult to maintain composure when a large part of the capital has been temporarily lost. I say temporarily because unless you throw the bath water with the baby, a good system will always see the previous high being re-claimed in due course of time.

Lets face it, you shall face a draw-down no matter which class of asset you put your money in (exception being Fixed Deposit). Equity Mutual Funds / Debt Mutual Funds even Real Estate face a draw-down at one or the other point if one takes in a sufficiently large time frame. 

Many mutual funds for example had a draw-down of more than 30 – 40% when the financial crisis hit the market and this is un-leveraged. Many stocks on the other side hemorrhaged as they lost greater than 50% as the crisis dragged on. So, deep draw-downs are not uncommon no matter what class of investment you choose to make.

The reason for the thought to write about draw-downs came to my mind basically due the exchange of tweets regarding draw-down in Titan during the 2008 financial crisis between Professor Sanjay Bakshi & Debasish Basu (Link). The stock under discussion was Titan which between its high in 2007 and low in 2009 fell by around 62.75%. If a 62% draw-down lasting more than 15 months will not psyche out someone, I doubt anything else can.

Its amazing that while we face draw-downs everywhere, including in life. its only in financial markets that we become paranoid and unable to grasp the longer term picture. Of course, even in life, weak minded people facing a stiff draw-down think of ending the life to end the pain, but for the vast majority, we some how are able to make up for everything and get back to our feet.

Being a very strong believer in systematic based trading, I regularly test ideas that either I develop myself or read about it somewhere else. The one thing that is common in most winning strategies is the huge draw-down. You cannot aim and possibly get 40% return without being ready to risk a draw-down of 60% – 80%. While its easy to talk about Risk to Reward ratio being at least 1:2 if not more, when it comes to draw-down, its always inverse.

One of the questions I am regularly asked is, How can I reduce the draw-down without it affecting the returns in a major way. Unfortunately, markets is all about give and take, you want to reduce draw-downs, you will face reduced returns as well. Just in case if you are wondering as to whether there exists strategies that have a very low draw-down while still having fairly good results, there are.

One is a heavily data-mined strategy which ensures that your historical draw-down is pretty low while compared to the historical returns. Of course, once you start trading that in real time you suddenly see that while the returns remain the same (at best), the draw-down goes completely off scale and unless one has prepared for it, chances of the system bankrupting the user is pretty high.

Second way is if you can game the system. While there is quite a bit of debate on whether HFT’s are gaming the system, I doubt you can have a record like that of Virtu Financial which had just one day of loss (and that too due to human error) while accounting for 1237 days of profit. While Arbitrage is said to be having low risk, this is something of a Zero Risk which is theoretically impossible (free money anyone?) unless they found a way to game the system.

Coming back, I believe that traders are more scared of draw-downs than Investors for two reasons. One, the trader is using leverage which easily balloons up the losses in a short span of time. Investors on the other hand generally have invested in full and would need to pay no more regardless of where the price goes. Getting a call from your broker to arrange for Marked to Market loss every other day can take a toll.

Secondly, a investor can avoid looking at the market for extended period of time during which the price may have come down and then bobbed up while a trader would be stuck to looking at every tick and hence pass through the emotions much quickly. If you are having a position which is under-water and loosing money every day and you hear the talking heads on TV giving out targets which would normally be preposterous, its tough indeed to sit quietly and wait till the things calm down.

Of course, does that doesn’t mean that a Investor is a winner in most situations while a trader is not since we have not accounted for a lot of cognitive biases that affect the way we look at things in life. I for one believe that a trader can compound money much faster than any investor (remember, Leverage is a double edge sword) but that is only if he is able to look at things not in the way its presented but in the way, its impact on the future is. 

To Conclude, a Big Draw-down is not necessarily bad and in the same way a small draw-down may not be necessarily good. Its all relative to something else (all the time) 🙂