Asymmetry - Focus your attention on what you can directly control.
Under modern portfolio theory everyone is aware of the tendency for risk to increase with returns...however there is an assumption in this notion that relates to investors/traders being rational decision makers. The reality however is not so straightforward. For example there are many examples in the equity market where a move into less volatile assets can actually result in enhanced returns when compared to more volatile assets.
Just another reason why you need to test every assumption in this 'mantra filled' investment/trading world. The reality is that traders/investors are not necessarily rational, and human biases such as the 'lottery effect' and a host of other human biases can be responsible for shifting the conclusions away from modern portfolio theory towards markets being inefficient at least some of the time.
But no matter what conclusions you have in relation to the risk-reward relationship, there is no question that risk will be an inevitable bedside companion to reward until of course the day when we no longer have to take any losses......no I don't believe in pink unicorns. There was a touch of sarcasm in this comment.
So here is the question. Have you ever really thought about the aspect of trading that you can actually really control....namely risk management, or has your mind always been focussed on the sexier end of the relationship.....namely profits? For example, do you want to get as much return as you can get with a given amount of risk and try to make every trade a winner....or do you focus your attention on protecting your trade capital through strict risk management and simply letting the market decide how much profit it will deliver to you? The mindset that accompanies these different perspectives to trading is significant in shaping how you interact with the market.
You like potato and I like potahto
You like tomato and I like tomahto
Potato, potahto, Tomato, tomahto.
Let's call the whole thing off
The lure of profits is a hard aspect of trading to dispel from the mind....but it might be time to flip the mind and wonder what could be achieved if you simply focussed your efforts towards that aspect of trading you can actually control.
As all of us recognise, positive expectancy is our long term goal of trading....but to achieve this you need an asymmetrical strategy. A strategy whereby risk versus return is not symmetrical but rather where on a per trade basis, we have more profits and less losses. Now in an efficient market, this asymmetrical fundamental relationship is where fairies exist.....but in a market prone to inefficiencies at times, this is where asymmetrical opportunities exist that are the bread and butter for concepts such as "cut losses quickly and let the profits run".
There are two ways to create this asymmetry that represent different ends of the spectrum:
1. Step into the world of prediction whereby your ability to forecast with fidelity delivers you enhanced profits compared to your losses assigned through your exit mechanism; or
2. Step into the world of risk management whereby you focus your efforts on strictly limiting your downside risk exposure (keeping your drawdown within your expectations) and simply letting your system breathe when in profit.
Option 1 tends to mean that we need to become specialists in prediction..and that is actually where actual risk lies (namely the risks of uncertainty). With this mindset we find that we prefer to focus on one or a narrow range of markets whereby we invest our efforts in understanding these markets and their nuances in detail thereby hopefully improving our predictive abilities. We become market specialists.....but what happens when market conditions change? What we find is that we very quickly enter drawdowns well beyond our expectations and are more likely than not to throw away our current failing system and look for another predictive system that responds better to current market conditions. The game of an Option 1 trader is full of stops and starts....successes and failures and the classic whipsaw and volatile life of a retail trader.
Option 2 under a dedicated focus to risk management however allows you to trade any liquid market and even those markets that many Option 1 types would consider high risk. It also allows you to stay a generalist as opposed to a specialist and is far more forgiving if market conditions change as your active risk management protects your drawdown exposure or at least ensures that your rate of entering an unfavourable drawdown is far slower. The game of an Option 2 type trader in general is therefore more boring, less spectacular/volatile but far more enduring and sustainable. On the flip side regarding your profits, you don't really care about where the market takes you as you recognise that with your systems open-ended nature, that simple market uncertainty means that at times an ineffiocient market may occassionally deliver you a windfall.
Under Option 2, we are never certain about anything, are boring at dinner parties, drive volvos, dress funny and wear horn rimmed glasses .......but you can never get rid of us as we never ever die! There are less of us in the retail world but we are immortal. We are the Connor Macloud's of the Clan Macloud :-)
Trade well
C
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Under modern portfolio theory everyone is aware of the tendency for risk to increase with returns...however there is an assumption in this notion that relates to investors/traders being rational decision makers. The reality however is not so straightforward. For example there are many examples in the equity market where a move into less volatile assets can actually result in enhanced returns when compared to more volatile assets.
Attached Image
Just another reason why you need to test every assumption in this 'mantra filled' investment/trading world. The reality is that traders/investors are not necessarily rational, and human biases such as the 'lottery effect' and a host of other human biases can be responsible for shifting the conclusions away from modern portfolio theory towards markets being inefficient at least some of the time.
But no matter what conclusions you have in relation to the risk-reward relationship, there is no question that risk will be an inevitable bedside companion to reward until of course the day when we no longer have to take any losses......no I don't believe in pink unicorns. There was a touch of sarcasm in this comment.
So here is the question. Have you ever really thought about the aspect of trading that you can actually really control....namely risk management, or has your mind always been focussed on the sexier end of the relationship.....namely profits? For example, do you want to get as much return as you can get with a given amount of risk and try to make every trade a winner....or do you focus your attention on protecting your trade capital through strict risk management and simply letting the market decide how much profit it will deliver to you? The mindset that accompanies these different perspectives to trading is significant in shaping how you interact with the market.
You like potato and I like potahto
You like tomato and I like tomahto
Potato, potahto, Tomato, tomahto.
Let's call the whole thing off
The lure of profits is a hard aspect of trading to dispel from the mind....but it might be time to flip the mind and wonder what could be achieved if you simply focussed your efforts towards that aspect of trading you can actually control.
As all of us recognise, positive expectancy is our long term goal of trading....but to achieve this you need an asymmetrical strategy. A strategy whereby risk versus return is not symmetrical but rather where on a per trade basis, we have more profits and less losses. Now in an efficient market, this asymmetrical fundamental relationship is where fairies exist.....but in a market prone to inefficiencies at times, this is where asymmetrical opportunities exist that are the bread and butter for concepts such as "cut losses quickly and let the profits run".
There are two ways to create this asymmetry that represent different ends of the spectrum:
1. Step into the world of prediction whereby your ability to forecast with fidelity delivers you enhanced profits compared to your losses assigned through your exit mechanism; or
2. Step into the world of risk management whereby you focus your efforts on strictly limiting your downside risk exposure (keeping your drawdown within your expectations) and simply letting your system breathe when in profit.
Option 1 tends to mean that we need to become specialists in prediction..and that is actually where actual risk lies (namely the risks of uncertainty). With this mindset we find that we prefer to focus on one or a narrow range of markets whereby we invest our efforts in understanding these markets and their nuances in detail thereby hopefully improving our predictive abilities. We become market specialists.....but what happens when market conditions change? What we find is that we very quickly enter drawdowns well beyond our expectations and are more likely than not to throw away our current failing system and look for another predictive system that responds better to current market conditions. The game of an Option 1 trader is full of stops and starts....successes and failures and the classic whipsaw and volatile life of a retail trader.
Option 2 under a dedicated focus to risk management however allows you to trade any liquid market and even those markets that many Option 1 types would consider high risk. It also allows you to stay a generalist as opposed to a specialist and is far more forgiving if market conditions change as your active risk management protects your drawdown exposure or at least ensures that your rate of entering an unfavourable drawdown is far slower. The game of an Option 2 type trader in general is therefore more boring, less spectacular/volatile but far more enduring and sustainable. On the flip side regarding your profits, you don't really care about where the market takes you as you recognise that with your systems open-ended nature, that simple market uncertainty means that at times an ineffiocient market may occassionally deliver you a windfall.
Under Option 2, we are never certain about anything, are boring at dinner parties, drive volvos, dress funny and wear horn rimmed glasses .......but you can never get rid of us as we never ever die! There are less of us in the retail world but we are immortal. We are the Connor Macloud's of the Clan Macloud :-)
Trade well
C
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