Quantitative Crypto Investing(5) - Risk Management or how your losses never exceed 20% of your equity Part 3

Last time, I told you about “Volatility Targeting” to dramatically reduce your volatility and maximum drawdown(MDD).

You might say: “Bitcoin went up 50fold in 4 years, and I should be satisfied with a CAGR of 32% or 15%? Are you kidding?”

But if had bet the full amount in Bitcoin, you would have experienced a 80% or 90% drawdown in 2014. Then there are two scenarios. 1) You curse a lot and give up investing. 2) You just wait and wait until you get even. That would have happened at the end of 2016 of at the beginning of 2017. Then you sell and are happy to have your money back.

Most investors, virtually everyone, sell if they get back to even after a prolonged losing period to avoid further pain. We have never seen an investor doing the right thing – just holding into it a bit longer and making a handsome return. Remember that an asset going up tends to rise further? That’s why it is usually wrong to sell after the asset has a furious run-up, bringing you to even.

So if you had invested like a man(?), betting the full amount, your return would have been -80% under scenario 1 and 0% under scenario 2. Our investment strategy, on the other hand, has a quite low(?) return, but it is still higher than -80% or 0% you would have got without a strategy.

Then there a so many people coming to us, claiming: “I only have 5,000 dollars to invest, I cannot invest that timidly.” We always answer the same way: “Well, if you have 5,000 dollars, winning 1,000 dollars is much better than losing 4,000 dollars, right? And don’t you think your equity will increase over time if you work and save some more money? You have to prepare yourself for the moment your equity increases to 50,000 dollars or 500,000 dollars. Learn the right investment principles and strategies first!”

Look, the market has gone down 90%, but the setback to my equity was much less when I use volatility targeting. Bitcoin and the other cryptocurrencies will never! Go up until eternity. There will be a huge bear market, and also sideways markets where nothing much happens. In all these markets, you must not lose have a MDD of more than 20%. Using volatility targeting, you can achieve this seemingly impossible goal.

So, last time I showed you that having my volatility at 1% brought my MDD down to 27%, while maintaining a CAGR of 32%.

This is pretty good, but not really good as the MDD is still to high. Is there a clever way to get the MDD down even more?

Well, let’s follow up with another great move. Didn’t we say that you should invest only in rising markets? What if we define rising market as “Price above the 5 days moving average” and use volatility targeting only in these days, leaving the market alone and not investing during the falling days?

▲ Bitcoin, Volatility Target of 1%, invest only in rising markets (2013. 10.~2017. 12.)

Let’s compare with the strategy in part 2 where we did not care about rising or falling markets.

▲ Bitcoin, Volatility targeting, comparing all market states and rising markets (2013. 10.~2017. 12.)

As you can see, if you had used volatility targeting in rising markets while not investing in falling markets, your returns would have gone up while the MDD was reduced by more than half!

We tell you once more – you should invest only in rising markets.

(continues)