Why Drawdowns are a Necessary Evil in Trading

Why Drawdowns are a Necessary Evil in Trading

This is a Guest Post by AK of Fallible

AK has been an analyst at long/short equity investment firms, global macro funds, and corporate economics departments. He co-founded Macro Ops and is the host of Fallible.

Losing periods of any trading strategy are a necessary evil. If losing periods didn’t exist for profitable strategies they would eventually erode away and cease to work.

To understand this concept think about where profits in the market actually come from. When you make a profitable trade someone else took the other side and lost that money. Free money does not appear out of thin air. So if your trading strategy never lost, the people on the other side of your trades would eventually run out of money.

For example, let’s say that you have an amazing buy the dip strategy that has an 100% win rate. Eventually the traders overselling the market would start to realize how much money their were losing by doing so. In reaction to that realization they would cease to sell the market out of fear and the “Holy Grail” buy the dip strategy would cease to trigger, robbing you of your opportunity.

Now what if the buy the fear strategy only made money 60% of the time? It would be a lot harder for the losing traders on the other side of your trade to figure out their mistakes and reverse course. Your edge in the market would likely endure.

If you look at Warren Buffett’s investment strategy it has been littered with large drawdowns and tough times. He looked like an investment idiot in the late 90’s. But those losing cycles were necessary for his long-term value oriented strategy to maintain its profitability over time.

The dynamics of a poker game help to further illustrate this concept. Because of luck, losing poker players can have winning sessions and even large winning streaks. This keeps the bad players coming back to play again and again even though they are long-term losers against the truly profitable poker players. If the quality poker players won every single time, the bad players would give up and quit, eliminating the profitable player’s edge all together.

And as always, stay Fallible out there investors!

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***All content, opinions, and commentary by Fallible is intended for general information and educational purposes only, NOT INVESTMENT ADVICE.