Nov

15

I found a fun and educational Equity Curve Random Generator where you can enter values of win/loss ratios and win probabilities and see their effect on returns over time. Note that increasing the number of lines (third blank) will overlay multiple runs on the chart. Playing with this revealed rather quickly that ratcheting up the win/loss ratio in tenths only gradually improves the curve, but ratcheting up the win probability in tenths rapidly improves the curve. Even hundredths are important. Try ratcheting the probability .55, .56, .57, .58, .59, .60 and you will see. Improving odds even a tiny amount can dramatically improve returns.

Dr. Phil McDonnell comments:

I would caution all that the author of the web site mentioned by Mr. Foust uses the Average Win/Loss ratio as his characteristic criteria. As Rick found the criteria did not seem to be the most helpful. Part of my caution comes from the author’s apparent use of the Average Win/Loss ratio in conjunction with the Kelly Criterion. The Kelly Criterion applies only to gambling games with binomial outcomes.

Some people have tried to extend it to multinomial outcomes such as we have in investments. They try to use the average win and the average loss as though they were binomial outcomes. In so doing they commit a basic arithmetic mistake. Implicitly they are assuming that the distributive law applies to logarithms. It does not and that is where they go wrong.

This error has been repeated to the point of being a meme. Many books espouse it, much software is written to calculate it and articles proclaim it to the unwary. The simple fact is that the incorrect formula invariably leads to over trading and will CAUSE the ruin which it ostensibly promises to prevent.


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