Market Myth #3 - Drawdowns are Avoidable

You’ve read Market Myth #1 and #2. You are no longer tweaking settings constantly or trying to figure out “why” the market does what it does. You have taken a zen like approach and watched the market, studied data, run hundreds of hours of backtests until finally you have found a profitable system. Like many profitable systems, it is long only, trades US equities and buys stocks on dips. The so called “dip-buyers” are quite prolific in the wealth-lab code library.

You go live with your system on 5/1/2007 and things are great, each day you buy a few stocks and they immediately bounce back. By the end of the month your starting account of $100,000 is up to over $105,000, a nice return of over 5% in it’s first month! Then on 6/5/2007, the market dips a bit, your system adds some positions, on 6/6/2007 it goes down some more and of course your systems adds more. You are 80% long going into 6/8/2007 and within the first couple hours you buy enough positions to use up all your available cash, however the market continues to decline. When the smoke clears at the end of the day, you’re account balance stands at $99,500. Down $500 from the start of 5/1/2007 and down over 5% from your peak.

You can’t help but be a bit disappointed to give back all those gains in only 3 days, 3 lousy days.  If only I’d sat out this dip, if only I’d reduced the position size, if only I’d waited longer to buy, if only, if only.  However, the real if only is if only I’d leave everything alone and keep trading the system as is.

Drawdowns are a fact of life, for any trader and especially a system trader.  They are to be expected and even welcome as often a drawdown come before a period of outperformance.  In this case, the drawdown was not even 6%, a tiny wiggle on that beautiful 5 year equity chart generated from baacktesting, but somehow looms much larger when you watch your gains wither away so quickly before your eyes.   The absolute worst thing you can do is try to avoid drawdowns, since by constantly changing strategies or systems to avoid the most recent drawdown, you virtually insure that your system will not be prepared for the next one and you will fail to outperform in up markets.   I’ve never seen a good system that did not have drawdowns of at least 10%+ and the system made famous by the Turtles often experienced drawdowns in the 30-50%+ range.  The difference between a successful and unsuccessful system trader is often the ability to stick with the system through the unavoidable drawdowns…

- John