RSSWhen Adaptive Systems Fail (and What I’m Going to Do About It)
By Michael Stokes | October 10, 2008 | 9:58 AM | 1 Comment
A little history for the uninitiated.
About six months ago we launched a new trading strategy YK that was a radical departure from our original MarketSci strategies. YK is adaptive, meaning it was built to "learn" from the markets rather than using more traditional static rules.
In our first 6 months of trading, in some pretty ugly markets, YK did amazingly well, returning an annualized pace of 150.8% with a peak month-end drawdown of -2.1%.
Then came the October stock market slide. As I've discussed recently, this month has been unprecedented. Never before has the market come even close to losing this much this fast in consecutive down closing days without a technical bounce. YK wasn't prepared for such a significant historical divergence and to put it bluntly, crashed and burned.
The strategy has lost over 30% this month. That's not a typo.
On a personal note, as I wrote in Psychology of the Drawdown, as a trader with thick skin born of many years going toe to toe with these markets, I take it all in stride. Hell, we've still outperformed the market by a healthy margin over the last 6+ months. But as a guy who folks rely on for market wisdom, I carry a pain in my soul that nothing I do from now moving forward can ever hope to assuage.
What Went Wrong
This part all sounds like common-sense (in hindsight).
The YK Strategy was built assuming that (a) markets act in accordance with history (all technical strategies make this assumption), but that (b) history is constantly evolving and so the strategy must evolve with it (this is the concept that I think makes YK so unique).
YK also implicitly assumed that when the market diverged from history, that divergence would be brief enough and painless enough that the strategy could ride it out. This month has proven that assumption wrongheaded - the market can stay irrational far longer than you or I can remain solvent.
It's important to note that I don't think the "adapting" portion of the strategy failed. The market has never moved this way in 60 years of history; there's no history to "adapt" from. What failed was the strategy's inability to recognize that the market could act in a way that's so much different than what's been seen before.
What I'm Going to Do About It
The basic concept behind YK is clearly not broken. Prior to the market slide in October, we were able to pull gains from up, down, and sideways markets that I've never seen a fund trading program do in real-time relative to its downside volatility. So the basic underlying concept doesn't need to be changed.
But YK needs a mechanism to recognize when the market is wildly out of sorts. I'm pursuing two avenues at this moment (warning: this part of the discussion will be a little geeky).
- The first options is something very simple such as moving to cash whenever the market moves beyond a volatility envelope (such as Bollinger Bands). The disadvantage of this option is that over the long-term it leaves some money on the table because buying into extreme weakness is (on average) very profitable. The advantage is that it without a doubt takes the strategy to the safety of cash when the stock market is doing something out of historical norms (assuming it doesn't get caught in a catastrophic down day, a'la October, 1987).
- The second is something a bit more sophisticated where in addition to looking at for example average expected returns for a combination of conditions when making its daily trading decisions, the strategy is also looking at outliers (such as the bottom 2% of returns) to try to gauge the potential for large losses given a combination of conditions. The advantage of this approach is that it tries to capture fat-tail risk before it happens. The disadvantage is that it doesn't necessarily do such a good job at capturing that fat-tail risk accurately - major losses often occur for reasons completely unrelated to technical factors.
So that's where we're at today. I banned myself from trying to cobble together a hasty answer this week while we're still in the fire. I want to make a decision that we can live with indefinitely. YK and I have crunched some preliminary numbers on each of the solutions above, and we'll be narrowing down the decision in the coming week (though I'm heavily leaning towards the more conservative solution #1). I'll be updating this blog with our solution as a diary of sorts.
Happy Trading,
ms
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