Managing risk through planning

Today is July 4th. For America, it is a day of celebration recalling the Declaration of Independence. As well as remembering the past, it is also a time to think about the present and to think about the future of America.

 

This year, more than any in the recent past has been a challenging year both in America and elsewhere given the pandemic. More recently we’ve seen protests triggered by the tragic death of George Floyd. It is all of course a reminder that time doesn’t move in an all together linear way, and over time, there will be periods of difficulty and progress will come to halt and in many cases reverse.

 

If we think back to July 4th 1776, it wasn’t clear what the result of the Declaration of Independence would be and it was essentially a leap into the unknown and conflict. In the end, it forged a new nation and as the twentieth century dawned, the “new nation” of America overtook the United Kingdom to become the world’s most power country.

 

Whenever, we embark on something new there is an element of the unknown, and we have to somehow manage that risk. If we’ve done very little research or investigation, that risk is going be very difficult to manage. Whilst we cannot predict the future, we can at least think about various potential scenarios and the possible upside (and of course downside!)

 

From a trading perspective this involves not only what conditions are required for your trade to go well, but more importantly what are the potential roadblocks along the way and what your losses could be. If we focus in particular on systematic trading models, this will involve understanding the distribution of your trading strategy returns, and looking at the right side of the distribution as well as the left side (or what are the potential drawdowns).

 

We also need to think about what regimes might suit the model best and have a plan when we wish to run it live. If for example returns are “unusual” (outside the usual distribution), we should have a trigger for us to investigate it. Obviously, where “unusual” means we’re exploring the left hand side of the distribution (the losses!) is more of a concern than when we’re looking at the right hand side (the gains!). This has been very apparent during recent weeks, when the fall and subsequent rally in stocks would not have been something you’d see often in historical data. There’s a book coauthored by Alexander Denev, Portfolio Management under Stress: A Bayesian-Net Approach to Coherent Asset Allocation, my fellow coauthor of The Book of Alternative Data, which looks at asset allocation when faced with a lack of data, which is particularly relevant at this time.

 

It is impossible to know the future, but we can at least prepare for some of the eventualities, before any of them happen. Whilst trading profitably isn’t easy, we often have a lot of historical data, which means that we can do a lot of research before we start trading, and have some sort of framework.