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Neal: Not everyone is a system developer. What criteria do you suggest an individual use to evaluate a system? Let me ask the elder statesman of the committee to answer. |
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Committee: There are numerous ways to evaluate a system. The two that I found most helpful to the individual investor are the Maximum Drawdown and the Sharpe Ratio. Maximum Drawdown is the maximum total dollars lost from the highest high of your profits to the lowest low. This is important to the investor because if he trades and goes into a drawdown, then all kinds of things can happen. As you go into a drawdown, feelings of anxiety increase and the resultant actions can be catastrophic. The investor can continue trading, stop trading, or modify his system. The last two usually work against him. A good system will weather the drawdown just fine. It is the investor who may not do so well. This is why I like Maximum Drawdown. Drawdowns happen to everyone. The question then arises regarding what to do about drawdown? Before buying a system, the investor needs to ask, "How much money can I afford to lose before my anxiety level rises to such a point that it makes me an ineffective trader?" I personally have a low threshold for anxiety. Therefore, I have set 10% as the maximum drawdown I can tolerate. |
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Neal: Many systems have maximum drawdowns greater than 10%. Is there anything you sacrifice by having a smaller drawdown? Let me direct this question to the member of the committee who trades a fund. |
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Committee: Yes, I sacrifice my rate of return. There are some systems that might offer a higher rate of return, but the drawdowns are usually greater. This is where individuals have to make their own decisions. If you can handle a 30% to 60% drawdown in order to get a higher rate of return, then more power to you. |
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