Risk Management and Learning From Our Losses

My recent post emphasized the importance of being an adaptive trader.  One of the most valuable tools in staying adaptive is learning from your losses.  If markets were unchanging--if they only followed a single regime, a single set of rules--then losses would be the result of poor rule-following.  Discipline is necessarily the greatest virtue in a static world.

If, however, markets are not static and their underlying rules shift over time, then losses can take on a different meaning.  We can trade in a fully planned and disciplined manner and still lose money.  That is because the markets themselves have changed.  When regimes shift, losses can become valuable information:  they are telling us that what worked in trading before is no longer working.  That is a wakeup call to revisit assumptions and develop a different trading approach.

This is one reason why risk management is so important.  We are not omniscient.  There will always be times when we are imperfect in anticipating regime shifts in markets.  That fallibility ensures that we will always have drawdowns.  We cannot adapt and bounce back if those drawdowns take us out of the game.  Good risk management means that we assume position size and portfolio risk at levels that we can tolerate should markets change their tunes.  It is very difficult to use losses as information and adapt to changing markets if we are traumatized by drawdowns.

Once we accept that the world is a dynamic, changing place, we become free to embrace drawdowns.  They are there for a reason; they can teach us something.  It's easy to lose the lessons in drawdowns if we respond to losses solely as threats.

Further Reading:  Risk Management and Trading Psychology