I’ve seen it written that every trader thinks that they will be able to withstand twice the drawdown that they will actually be able to tolerate.
This is the root of Tolerance Bias, which is a trader overestimating his ability to tolerate drawdowns. A bias that is entirely psychological.
Tolerance bias is also a very important step in creating a trust in your trading system.
Let’s take an example. You’re looking at a strategy with 20% Max drawdown. You start trading and it immediately starts into a drawdown. You go back and check the algorithms metrics and you see over the last 7 years the max duration drawdown is thirteen months. Can you stick with this system for thirteen months underwater? Probably not.
Or, once the system gets to a 15% drawdown, well within the metrics of the system, you bail. Jack D. Schwager, author of Market Wizards, says most will bail once they hit 10%.
While it is easy to look at the overall return of the system and agree that it was profitable, it is naive to think that it would not be a challenge to stick to the system at its low point.
You need to take these numbers into account when deciding on a mechanical system. Well, actually you need to take these numbers into account when trading any system.
If you find a trading system that is profitable, you need to trade it long term, or at least as long as its longer drawdown. I have not found a service anywhere that will give you the Max Drawdown duration, except QiT, of course, but it is a very important number to know.
While this can be challenging, you must find a way to stick to the plan.
The best way to circumvent tolerance bias is to dramatically underestimate your drawdown tolerance.
We’re the Plan in “Plan your Trade and Trade your Plan” – TraderJanie
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