Loss-Aversion and the Impact on Performance

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Most traders are concerned about their performance – and for good reason: trading is after all a performance-based endeavour. However, whilst retail traders boast about their nominal performance figures of 100+% and some trading competitions see traders make 1000+% in very short periods of time, professionals think differently.

In the professional world it’s all about risk-adjusted returns. Hence the focus on Sharpe Ratios, MAR Ratios, SQN numbers and so fourth. In this brief article we shall offer a practical explanation as to why the risk-adjusted return (i.e. the volatility of returns) is what people are most interested with.

Loss Aversion is the Key

“When the pain from intermittent drawdowns can exceed the pleasure of intermittent gains, even if those gains are greater than the losses cumulatively, it hurts. It hurts whether you are suffering the move that creates higher “expected returns” and it hurts if your “volatility” increases vs. a benchmark, and no matter where things end up, that journey – emotionally – feels more important than the destination.” – Clifford Asness, AQR

Whether we are talking about long-term, medium-term or short-term holding periods, every investor is emotionally more attached to the volatility of returns rather than the end return itself. While the end performance matters, the actual path that took the portfolio from A to B has a stronger emotional impact.

For example, look at these three performance curves. The first trader made around 300% with a MaxDD of 90%. The second trader made around 170% with a MaxDD of around 70%. The third trader (which is one of our own members here at FXRenew) has produced a return of 77% up to now, with a MaxDD of about 7%.

Which trader would you place your money with? The answer will likely be tied to the emotional impact of the “journey” and in this case, trader 3 would be my personal selection. Professionals look for the same things all the time:

  • Sharp Ratio/SQN Number
  • MAR Ratio (Geometric Return/ MaxDD)
  • Recovery Time (time that passes between equity peaks)

The Never-Ending Journey

At the beginning of my favorite TV show, Star Trek The Next Generation, a superior life-form by the name of “Q” puts Capt. Picard on trial as a repesentative of all humanity. The accuse? That humans a savage child-like race. Fast-forward 7 seasons into the finale and we once again see “Q” judging Picard in the courtroom. What’s interesting, for our current conversation, is this line:

PICARD: I sincerely hope that this is the last time that I find myself here. 
Q: You just don’t get it, do you, Jean-Luc? The trial never ends. 

As traders, our trial never ends. There is no pot of Gold at the end of the rainbow because we are constantly trading, constantly performing, constantly trying to improve ourselves and attract investor capital. This is a life-long journey. You cannot perform well for a season, and then call it quits. (I guess there are some exceptions but the rule holds)

From this point of view, maintaining a smooth ride should take precedence over all else.

Traders are very much risk managers first and foremost.

Over to You

Could it be that you’re focusing too much on the absolute return, potentially risking your entire account in pursuit of 100%+ returns? Or are you jumping on every trade without properly assessing the ex-ante Risk-Reward profile of them?

In either case, know this: if you do wish to transition from the retail world to the professional world of money management, your absolute returns mean nothing. It is your risk-adjusted return that matters most. The sooner you get familiar with Sharpe Ratios, SQN, Mar Ratio, Recovery Time, and other risk metrics, the better your chances of success.

What to do? Simple.

  1. Connect your account to an independent tracking source (MYFXBook, Fundseeder, etc.)
  2. Trade consistently, always thinking about risk limits, risk-reward and quality trades.
  3. Track your statistics for 8-12 months.
  4. Show us your results.

And as usual, get in touch if you need pointers or get stuck. We’re here to help.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals and Education from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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