Tuesday, June 24, 2008

The Psychology of Risk and Return




Here is an absolutely phenomenal resource from Henry Carstens that takes your average win size per trade and the standard deviation of your daily returns and generates, Monte Carlo style, plots of your forecasted P/L curves. If you play with the two parameters, you'll see how changes in your risk (variability of your returns) and reward (size of your average profits) affect your overall results over time.

Imagine a $100,000 portfolio that averages, over the course of two years (100 weeks) a return of 50 basis points (1/2% or $500) profit per week with 100 basis points (1%) average variability per week. That would be a high Sharpe ratio trader. In the top chart, we see what that gets you: a pretty smooth equity curve and a return of about 50% over those two years.

Now let's imagine the same scenario but with double the variability of returns (middle chart). Notice that the end result is slightly better, but our P/L curve is much less smooth. There is a meaningful drawdown, peak to trough, along the way that lasts for over half a year.

Finally, let's imagine that markets change and our edge is cut in half as the volatility of our returns is increased (bottom chart). Not only do we make much less money--about 22% over the two years--but the pattern of returns is quite lumpy.

All of this has real psychological implications. When markets become more volatile and when market patterns change, we can go from scenario 1 to 2 to 3 rather easily, with exactly the same skills sets we've always had. The reduced returns and choppier path of returns can prove frustrating, leading traders to change their trading and further complicate the problems. Imagine, for instance, if our excellent trader in scenario 2 became discouraged during the drawdown period and stopped trading. Much potential profit would be lost.

Try Henry's forecaster by generating multiple possible forecasts for exactly the same parameters. You'll see that chance alone will affect the paths of returns. A trader who understands that it's not just about returns, but risk-adjusted returns, can best adapt to these trading realities.

RELATED POSTS:

Decision Making and Risk

Risk and the Biology of Trading

The Psychology of Risk Management
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3 comments:

Bollywood Hub said...

hi
its good to have such a well known trader blog on the internet
I love the stuff you write about . i have added your blog to mylinks on www.netmillionare.blogspot.com

Brandon Wilhite said...

That IS an excellent resource; and you're spot on with the psychology of it as well. Like you said, the variability of returns due to chance alone is eye opening to see. It's also both humbling and comforting at the same time.

Thanks for the post.

BW

Brett Steenbarger, Ph.D. said...

Hi Brandon,

Yes, indeed, that chance factor is mightily underestimated when people think of their returns. Many different shapes for equity curves based on the same trading just as a function of when the winners and losers manifest themselves--

Brett