In order to make trading systems more antifragile, we must focus on changing their risk exposure. If your primary concern in trading is your system’s profitability, then you are setting yourself up for an epic failure. The first and foremost concern of any trading system absolutely must be the risk within a system.
Risk of Ruin
In Book III of Antifragile, Nassim Taleb presents the argument that profit is a secondary goal in business. He argues that anyone who primarily focuses on profit is underestimating their risk exposure.
This concept applies directly to trading systems. Far too many traders use potential returns as the measuring stick for a trading system. Following Taleb’s argument, traders should put far more emphasis on the nature of the system.
“This fragility that comes from path dependence is often ignored by businessmen who, trained in static thinking, tend to believe that generating profits is their principal mission, with survival and risk control something to perhaps consider – they miss the strong logical precedence of survival over success.” – Taleb
While generating profits is certainly the end goal of any system, the ability to generate those profits requires the survival of the system. If the system goes bust at any point, then those future profits mean nothing.
Even if the system generates huge profits for years, if there are significant risks that could eventually catch up to it, then the system is just trading on borrowed time. The most important criteria for assessing a system’s fragility is its risk of ruin.
The least desirable way to protect against risk of ruin is to decrease the fragility of the system. This may sound like common sense, but far too many traders never make the connection.
As I covered earlier this week, there are three way of doing this: increasing the system’s win rate, increasing the system’s profitability, or decreasing trading size. Of these options, the only one that is completely in the trader’s control is the amount of risk their capital is exposed to.
Sensitivity to failure is best analyzed by adjusting the accuracy percentage and payout ratios. If you trade a trending system and the average payout drops by 20%, what happens to the system? Many trending systems completely fall apart.
Sometimes, a difference of 10% between the historical returns and future observations makes the difference between decent profits and huge losses. This is far more true when the expected percent accuracy falls and the payoff falls, too. Minor errors in observation lead to drastically different outcomes.
Fragility is Relative to Upside/Downside Risk
In the preceding chapter, Taleb explains that fragile systems have more to lose than they can gain. The opposite is true for antifragile systems. They have more to gain than to lose. They have a limited downside.
“You are antifragile for a source of volatility if potential gains exceed potential losses (and vice versa).” – Taleb
This further supports the argument that risk of ruin should be the primary concern when evaluating a trading system. Regardless of the system’s apparent upside, if the downside is too great, the system is no good. If the potential exists to lose everything, there is no possible upside that can balance that.
Long Term Capital Management
Taleb uses the example of a gambler to illustrate that no matter how good his strategy is, if he is exposed to the risk of losing everything then nothing else matters. The same can be said of anyone who’s trading system exposes them to too much risk.
It doesn’t matter how efficient the strategy is or how impressive the returns are if the risk of losing everything is too great. Risk of ruin trumps all other factors because it has the ability to end the game.
Long Term Capital Management (LTCM) provided an excellent example of this concept in the late 1990s. The fund was believed to have superior strategies implemented by brilliant traders and many investors expected the strong returns to continue indefinitely. The problem is that no one was concerned with the downside risk, leaving the fund vulnerable to a Black Swan event, which happened in 1998.
The combination of some unexpected events with a big appetite for leverage proved to be disastrous for LTCM and its investors. LTCM believed that it had smoothed out volatility and could provide consistent returns. As we all learned, the short-termist obsession with pretty Sharpe ratios on high leverage came at the cost of making a blowup inevitable..
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