What cockroaches can teach traders: reading list

A well-defended cockroach. Source: Google images.

A well-defended cockroach. Source: Google images.

The latest on my reading list is A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber.  It’s a bit dated, but right on the mark for what was to come in 2008.

The author’s experiences with risk management in a world of increasing financial complexity is the main theme of the book.  Now that I’m nearing the end, I’ve found a tasty morsel of advice for systematic traders – or, indeed, just about anyone.  Seek simplicity and robustness in system design/management.  The author uses biological systems for his metaphors; in this case, the very simple defence mechanism of the cockroach results in lots of false positives (i.e. the roach is too conservative), but is therefore well equipped to handle the unknown unknowns of the world.  His counterexample is a fish in Lake Victoria: very specialised for its environment – but gets wiped out when a foreign species is introduced.  Though the fish was perfectly designed for its environment – optimal in a lot of ways – it was ill-prepared for external shocks.

This reminds me of several folks’ ideas of systematic trading: why can’t we just program the algorithm to take all the (in hindsight) obvious precautions to avoid losses?  Well, aside from the observation that many of the precautions actually cost us in the long-run, a hyper-specific trading system is basically useless going forward.  The markets continue to make fools of us all; therefore we need to choose systems which have more robust (read: simplistic) trading and risk management.  Not only will that probably keep us profitable as markets change, they will probably be better equipped to survive external shocks.

As an example (but not meant as a plug): trend-following strategies are beautiful to me.  They’re extremely simplistic trading rules, with built-in risk management.  The latter is usually pretty blunt (e.g. stop-losses, or just signal reversals), but means good risk control in a variety of cases.  That’s probably why trend-followers have been around for decades, quietly churning decent – though maybe not show-stopping – performance through crises and more normal times.

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