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What do you mean I might lose money?
By Darren Merwitz | July 31, 2007
If I told you I had two systems that you could invest in. One has returned 30% year to date, and the other has returned 10%. Which one would you invest in?
Whichever answer you gave is wrong. Why? Because you can’t make any decision based on the performance of a system without considering the risk! This is because your return (or reward) needs to justify the risk (or uncertainty of that reward) taken. You can’t look at returns without considering how much money you are risking to achieve those returns.
As a more obvious example, say I told you if you gave me $10,000 I could achieve 100% return for you by tomorrow. So you give it to me, I drive down to Atlantic City and put all $10,000 on red on the roulette table for one spin. I may come back with your 100% return, but there is also about a 51% chance you will end up with nothing. Is that a risk you want to take? Possibly. But this highlights how you cannot just focus on returns.
OK, so now you know you have to take risk into account, but how exactly do you do that? There are no hard and fast rules for determining what risk an investment has. Risk can be tricky to measure, but there are some common ways. You can consider risk by looking backwards (at past live results), and by looking forwards (at trading practices). For past live results, my two favourites are:
1. Maximum draw-down (biggest drop in returns)
2. Standard deviation (volatility around the average return)
Obviously, as is stated on every investment website, past returns are not indicative of future results, but it does give us a good idea of the types of risks that are possible. The system could simply have been lucky thus far. If a shake up happens, things could change very quickly (a lot of ranging systems have experienced this recently). This is why looking forward can also be helpful. Some examples of what you would consider for this include:
1. Leverage
2. Volatility of currencies traded
3. Correlation of strategies, currencies within the system
In the end, the whole purpose of these measures are for you to be able to tell if your potential reward for your system is worth what you are subjecting your money to.
Your base, risk-less cases are instruments like CD’s, term deposits and Treasuries, for which you obviously receive very low returns, but they are essentially risk-free. As you invest in instruments (or systems) with higher expected returns, you would expect your risk to increase. Hopefully using some measures, like the above, you can make sure that the additional risk taken on is worth the additional expected return.
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Topics: Systems Trading Blog |