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Have you ever been surprised by something that’s happened in the markets? By how quickly a stock has moved or by how quickly the market has tanked? I certainly have. And back in 2008 when the market turned down, it turned down very, very quickly. And yeah, the bull market was pretty big and pretty fierce. And a lot of stocks, particularly financial stocks, really came down crashing down to earth really, really quickly. And look today I’m walking here in another Redwood forest in Northern California. And I don’t know if you can get an appreciation of the magnitude of these trees, but these are hundreds of feet tall. And to be completely honest with you, I would never have believed that you could get trees this big if I hadn’t seen them for myself. Now there’s a real danger here for traders because a lot of traders just don’t believe that something big and bad will happen to them. Because they haven’t seen it yet.
And there’s no big deal if you don’t believe that trees can get this big right? Until you see them. It’s like it doesn’t have any impact on your life. But if you take that belief that you have to see it for it to be real into your account, then something is going to happen that’s going to affect you and hurt you in the markets. One of the most interesting principles or concepts that I’ve heard is that the variants in the financial markets is infinite. Now, what does that mean? What that means is the more data you get, the bigger the variation, the standard deviation of a price moves becomes. Now what does that mean? That means that your biggest drawdown, the most extreme event that you have ever seen, is in your future. It’s not in your past. And that means as a trader, you need to prepare for adverse events that are bigger than anything you’ve seen before.
Now that has huge implications for your risk management and for your back testing for your system design. Because you cannot just have a look at the history of the stock market. The trees that you’ve seen, the trades that you’ve seen in your historical data, and assume that, that’s as bad as it will get. You actually have to design your systems, angel risk management to take into account the worst in your past. But also the potential worst in the future. Now that means being way less aggressive than what your back tests suggest you should. Now this is a conundrum, right? Because most people, most traders, particularly new traders want to be aggressive and make money quickly. And then they get to backtesting and go, “Holy cow, if I risked that much money on each trade, I blow up my account.” It’s like, “But you know what? It’s actually even worse than that. Because your biggest drawdown is in your future, not in the past data.|.
So do your back test. Yes. Design your system and your rules so that your historical drawdown in your back test is tolerable. But also you need to have a mind and an eye on the future and how bad things could possibly get. How big the moves could possibly get. Because you want to make sure that you will survive regardless of what happens in your future. If you’re going to survive, you are going to have to trade in a way that’s going to keep your account alive.
Now, I can tell you, if you’re going to trade for the next 10 or 20 or 30 years, you are going to see drawdowns that are bigger than anything you’ve seen in your past data. You’re going to see shocks in the market bigger than anything that has happened in the last 20 or 30 years in living market memory. And you better be prepared for that as a trader. Because if you’re going to survive and you’re going to win, you have to trade through those events that you’ve got no historical precedent for. Because the drawdowns and the adverse events get bigger and bigger as time goes on. So trade conservative, don’t use too much. Leverage small position sizing. And when you’re back testing, you’d got to make sure that your maximum historical drawdown is well within the tolerances of what you can comfortably stomach.
My name’s Adrian Reid. This is Enlightened Stock Trading. If you want to improve your trading, and if you want to get confidence despite all of these risks that you face in the markets, then click the link below and download my trading system confidence cheat sheet. And going through that cheat sheet, you’ll figure out how to make your trading rock solid. How to bulletproof your confidence so that you can follow your system no matter what happens in the markets. Again, my name is Adrian Reid. This Enlightened Stock Trading. Click the link below and download my trading system confidence cheat sheet. And I’ll see you in the next video. Bye for now.