Drawdowns

One of the hardest things for new traders to deal with is drawdowns.  Even traders that have a system with a backtested positive edge have trouble stomaching drawdowns well within the parameters of “normal”.  To use an example from real life, look at our system on Collective2.com.  We tell everyone to expect maximum drawdowns in the 25-30% range.  Everyone nods and their head and says “no problem”.  Now fastfoward to today.  Based on recent market action, the portfolio was 100% invested (as it should be), just last week it touched an all time equity high, just short of 112,000 and up 12% from it’s inception in late Feb.  Now after a week of rough market activity it’s down to ~$107,000 (and with NTRI’s afterhours performance, probably down a few grand more).  We’ll guesstimate ~$105,000 is it’s current value.   Over half the gains YTD gone in one week.

Is the system  broken?  Did we do something wrong?  Should we have been less  invested today?  The answer to all these  questions are NO.  Remember in the first paragraph where I said to anticipate max drawdowns inthe 25-30%range?  This drawdown is only 6.25%.   Miniscule compared to historical drawdowns.   A 25% drawdown (similar to one seen in Dave’s blog’s portfolio in 2006) would take our 112,000 portfolio down to $84,000.  Will we experience a drawdown like that on our collective portfolio?  Absolutely.  Is this the beginning of that drawdown?  I have absolutely no idea and neither does anyone else.

If this size drawdown makes you uncomfortable, it’s going to be difficult for you to beat the market by a significant percentage.  The fact is that to outperform you have to have exposure and with exposure comes risk.  The ratio between avg return and max avg drawdown is alot closer to 1.5:1 than most people would like to believe.  It is simply not practical to think you’ll be able to get avg 60% returns with max 5% drawdowns.  To average 60% returns, expect to see potential 40%+ drawdowns.  Remember, any positive system can give you 60% returns with enough leverage, it’s just a matter of how much the drawdown will be and if you’ll run out of money first.

- John