Home > trading > Traders Roundtable: Maximum Compounded Return Versus Fear of Drawdown

Traders Roundtable: Maximum Compounded Return Versus Fear of Drawdown

In a recent traders roundtable discussion on the subject of balancing maximum gain with risk management the question was posed how to reconcile these two issues. A few definitions for the purposes of this essay are in order.

First let’s consider maximum compounded return to be defined as a system that is traded at every viable opportunity at the maximum level of acceptable risk with profits that are rolled into the total portfolio and with maximum acceptable risk in leveraging the markets money. This definition allows us to stay within natural risk limits but operate the machine as close to the red line of sustainable performance as possible.

Now let’s consider the fear of drawdown to be defined as the natural human response to operating power tools or heavy equipment in a dangerous setting as close to the edge as possible with full recognition of the consequences implied of potentially catastrophic failure. The human mind is capable of creating shades of distinction between various perceived levels of risk and these degrees of perception vary by individual. Some people are fully physically capable of walking within 5 feet of the edge of the balcony where as others can go right up to the edge and peer over and still remain in full normal natural control of their reactions. For each person though there is a line beyond which you judge that you are in dangerous territory in that extraordinary measures of protection and care must be taken because of the increased risk.

I am certain that there is a lot of evolutionary biology involved inside our brains which had to face this exact challenge on every front in prehistoric times or more technically, in the era of evolutionary adaptation. Even the most primitive caveman was certainly capable of appreciating the pay off of killing a mammoth for the future of survival needs of the tribe. And yet that same caveman was fully aware of the danger to himself that he took by stocking the huge beast. Sharpened by fear and hunger in the visions of a plentiful tomorrow, each caveman had to reconcile distention in some fashion and the successful ones passed on their adaptations to countless generations. This manifests itself in modern times in any place where risk and reward are brought together and we asked humans to make a balanced trade-off decision.

In every significant situation, and by significant I mean where impactful money is being rest for an impactful reward, the brain is flooded with chemicals which trigger flight or fight responses and invoke millions of years of stored up collective unconsciousness which shape and color our decisions and effectiveness of implementing those decisions. Trading is no different.

My sense is that for long-term safety and survival and given a trading system that generates a significant number of opportunities that long-term survival should drive us towards finding the minimum level of risk with which to trade to meet our specific financial goals. For those whose goal is expressed as maximum compounded rate of return, I suggest they are more likely than not to push it past the red line and come crashing down.

Without an appreciation of the real cost and friction associated with long-term trading in multiple market conditions that require constant adaptation is too easy to extrapolate the results of a few successful trades into next taxation that is far from being achievable. These false expectations are more likely than not to add to the level of stress and further degrade performance. My sense is that minimum risk levels rather than maximum risk levels are appropriate place to begin your inquiry into long-term trading as a potential career.

Therefore, I strongly suggest that you start with ways to use part-time small position sizing trading and learn to supplement your current income at your current standard of living and proceed in small stages, and getting larger only when supported by the evidence of long-term performance. It’s an incremental approach, it does not generate lottery size winds, but it will keep you in the game while you’re learning and keep your feet planted firmly on the ground.

  1. August 4, 2009 at 8:03 pm

    I agree with that Ken, I mean that commentary speaks to me in a way as in I can identify with the “you”.

    Here I take away,

    trade small, don’t be stupid until you know what the you are doing or I promise you your gonna blow out and to the contrary your gonna trade better when you trade big if you trade small first.

    But I would prefer to fight and eat a mammoth with a dopamine and cortisol spike when I can use my body as it was designed and die with glory fighting the mammoth than to live in fear of a contrived negative real rate of return that requires a brisk walk to work off.

    And I digress again to make the political comment that it fills me full of chemicals as a citizen that “to save in a simple way” as in a

    a grandmother putting cash under the mattress,
    a farmer getting aggressive and buying a CD
    a salesman, craftsman and secretary et cetera to buying and holding

    have never been low risk options and inflation and deflation are not archetypes

    but the people who are not risk takers rather who put away for a rainy day are the ones who are being punished for lack of simple ideas such as a savings account that makes sense.

    That it is difficult to find a cellar to hoard acorns and salt ham makes me want to do battle with a mammoth. I mean that it behooves me to do so as well as it makes me angry and want to fight something.

    What brings me here is that my gut and the evidence show me Tortoise 2.0 is the best fair shake a guy or gal can get and the safety elements are built in

    That it functions as a savings account for the average citizen at the very least.

    That trading with systems with positive expectancies can be either a form of Mammoth hunting for meat or for fun.

    That should probably be post separately.

    I have a tendency to jump all over the place and I’m Ok with that but I bring it up because it’s also ok with me if if you don’t try to address topics that move from one subject to another as in my case.

    I very much like the two notions of Span of Control and the belief that if there are 3 important areas to trading then which ever one is weakest for you would be the primary limiting factor or something like that. I’m usually good at one thing and no good at the other thing (record keeping)

    I also very much like the idea that maybe Stan brought up; thathe got exposed to Berkshire Hathaway but didn’t get involved in it and later he forgave himself. He didn’t get it at the time, so in retrospect even though he missed out he had acted responsibly.

    I also read that when you use narrative or something that you should try to keep the number of ideas to a minimum. I’m sure however that it is important for someone who post articles to get some kind of feed back else it would be frustrating so I post here in that spirt when I am moved.

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