Quick Thoughts on Drawdowns and The Importance of Understanding Return Distributions of Strategies
One of the most important components of a good system is to have a low drawdown relative to its average return. Most traders make a concerted effort to pursue strategies with low drawdowns. In fact, people are so focused on drawdowns, that it is often detrimental. To me one of the most important things when considering drawdowns is WHEN they occured. Drawdowns that typically start after periods of strong profitability are far more desirable than equivalent drawdowns that start during flat or even poor periods. Few traders consider this, and that is why few people pursue trend-following because of the high perceived drawdowns. What is not mentioned is that most of the time these drawdowns occur AFTER high profitability. In contrast, short term strategies can “spontaneously combust” especially if they are poorly conceived. Even worse is that fact that commissions and bid-ask spreads can crush these strategies to bits right from the start. You will be down 50% with no chance for recovery from the get-go even though the strategy curve had low drawdowns in retrospect.
The often irrational desire for ultra-low or no drawdowns is the main reason why the Madoff scandals of the world occur in the first place. No one seems to be able to resist a straight line equity curve even at the expense of lower returns. The straighter the equity curve the less questions people ask about how the returns were generated. Many strategies secretly contain non-linear payoffs such as risk arbitrage or selling options, or ponzi schemes. Another silent but deadly killer in this area are “overfitted” strategies with more than 3 rules and les than 20 trades. The reality of statistical significance is that there will ALWAYS be rule combinations that peformed phenomenally well with 100% successful trades. The chances of them repeating their performance in real life depends on how and when you did your testing. These strategies appear wonderful until they blow up and never recover.
The bottom line is, even if you see a perfect equity curve, always ask yourself why a strategy should continue to perform the same way in the future. Also ask yourself whether certain conditions would cause your strategy to have non-linear payoffs. Solid human judgement in this area is absolutely unavoidable.