Most automated traders bases the evaluation of live performance of a strategy on pure instinct: short term gratification or pain. They don't even realize this, and this is one important reason why most of them are long term losers.
Instead of going through the technical steps to properly analyze live trading -this might go on another article- I prefer now to talk about how our instinct affects our decision process when analyzing live trading results of a strategy.
The thinking process of our brain
Our brain is good analyzing a series of facts and taking decisions based on those facts as long as there are no more than 6 or 7 elements involved. When it needs information stored in our memory, it is able to bring this information and include it in the decision making process.
Our long term memory works by grouping similar events. For example, if I was bitten by a dog when I was five years old and it happened again when I was 12, both events are grouped in our memory. The common elements are reinforced, specially the feelings we had (for example, "I was terrified when the dog bite my hand") and the different elements are much weak in our memory (for example, the first dog made me bleed but the second didn't).
This is very efficient and makes a lot of sense. The next time we see a dog our experience will let us know that it can bite our hand and will make us fear those bad feelings we had from past experiences.
Another important point is that our basic instinct "objective goal" of any decision making process is short term gratification (or pain removal). This is very good too, as it guarantees that we will try to run as hell if we are going to be eaten by a tiger or we will eat something when we are hungry. It requires an intellectual effort to ignore short term gratification or pain to achieve our long term goals.
How our instinct tries to analyze trading performance
While the described mechanism of our brain is generally a good thing for our lives, it is bad to measure performance analysis.
First of all, a loss is a painful experience for our brain and a win is a grateful experience for our brain. Following the mechanism described above, a loss is stored in our brain on the "group of losses". The common things are reinforced (loss, pain, immediate past losses, ...) and the different and complex things are weakened (size of the loss, long term performance, ...).
A loss is painful no matter the size and a win is a pleasure no matter the size. It requires a bit of effort to understand what is the real performance ignoring what our basic instinct is telling us after a recent losing period (run!) or a recent winning period (increase risk!).
In the following picture I am showing the performance of three Robin VOL months in 2010 and how our instinct understands this results:
Three bad months passed and our brain is sending us signals that we should stop the pain. The chosen period is not even the worst period, but just a normal and common drawdown period on this strategy.
Three months on the long term is nothing. After a winning period our brain will send us messages to increase the risk and after a losing period our brain will want to stop the pain and reduce the risk or remove the strategy from our portfolio. Both are bad decisions. Instead of making a rational decision it will be our instinct fooling us to take a bad decision.
How to overcome this handicap of our brain?
Why we sabotage ourselves? Because as we don't really understand the strategy and we don't trust it, so basic instinct is the only thing we have to take decisions. Our instinct will always assign great importance to short term results (recent pain or gratification). If you don't have confidence, you will stop the strategy and jump to a new one until the drawdown period comes for that new one too.
Confidence in your strategy is what will keep you trading through drawdown periods. But one cannot decide to have confidence in a strategy! The confidence must be earned. And it can only be earned making an intellectual effort. Otherwise, our instinct will take decisions for us.
The confidence is earned in two steps:
- Understanding the statistical characteristics of the strategy
- Understanding what is really happening once we trade live (confirming statistics)
During live trading, our confidence will grow every time a drawdown period is followed by a new equity high. So the first months of trading a strategy will be the most difficult ones.
If we deeply believe that our analysis about future performance is correct and live trading is performing as expected by the analysis it will be much easier to keep trading a strategy during a drawdown period.