returns and assets under management, inspiring thehumble admiration of the saplings that comprised the majority of its neighbors.Unfortunately,  one  of  the  laws  of  the  forest  is  that  even  its  mightiestdenizens  eventually  yield  to  the  forces  of  nature;  and  by  the  time  the  leavesbegan to turn in 1998, it was apparent to most observers that the salad daysof  our  angular  protagonist  were  very  much  behind  it.  However,  like  all  greatwarriors of the untamed market wilderness, the fund was destined to experi-ence its fall in the throes of battle—and not by its unilateral withdrawal fromthe arena in which it had so long reigned as champion.
Did it get bested in a single, defining incident? Hardly. These things seldomare  as  clear-cut  in  the  markets  as  they  are  in  nature.  Looking  back,  however,there is one event that stands out above all others: a massive bet, gone awry,that  one  of  the  world’s  benchmark  commodities  would  devalue  significantly,relative  to  one  of  its  peers.  I  don’t  know  how  big  the  exact  position  was  andcouldn’t even verify with certainty that the trade actually took place; but accord-ing to widespread market scuttlebutt, it amounted to several billion dollars.
That there were sound fundamental justifications for this position thereis little doubt. Some of the smartest commodity traders in the world had beenpredicting such a shift in sentiment for many a month. Speculative frenzy hadpushed  the  commodity’s  price  to  well  beyond  where  its  natural  sources  ofdemand could continue to make use of it. The fact that they were starting toutilize less efficient substitutes was evident in the price action of these com-modities. Many speculators who had ridden the upward trend to once (or per-haps twice) in a lifetime profit levels, were rumored to be getting out while theystill could.
The problems here had to do with size and scale. Against the backdrop ofthe Russian default, the collapse of Long-Term Capital Management, and a rap-idly  deteriorating  state  of  capital  markets  on  a  global  scale,  even  the  most
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intrepid  investors  were  busy  engaging  in  wholesale  portfolio  liquidation  in  afrenzied effort to accumulate cash and consolidate losses. Then, one afternoon,there was a multi-billion dollar bid for a clearly overvalued commodity. Quickly,quickly, the market surmised that a large hedge fund was liquidating its largestholding—and  rumors  flew  about  the  relative  level  of  duress  that  precipitatedsuch liquidation. Our redwood was known to have been badly wounded in theRussian debacle; and as nature has ordered, nothing that moved wanted to riskbeing  in  the  path  of  the  giant,  if  by  chance,  it  were  to  come  crashing  to  theground.
All  of  a  sudden,  there  were  no  offers  for  the  overvalued  commodity,  asafore-mentioned  and  newly  endowed  speculators  decided  that,  gosh  darn  it,maybe the commodity wasn’t so overvalued after all. Over a two-day period, itrallied another 20%. None of us who witnessed this activity could ever recall asingle trade on the part of an individual investment entity ever causing such amajor price disruption in a market generally thought of as being so liquid thateven the world’s leading central banks could only effect changes a fraction thatsize, and this only with a concerted, coordinated effort.
Though  its  formal  demise  didn’t  take  place  till  a  couple  of  years  later,everyone could see that the mighty sequoia, which once, as the saying goes,looked like it would indeed grow to the sky, was losing all its sap. Join me ifyou will in bidding it a fond, if belated, adieu. We are not likely to encounterits like again in our lifetimes.
The concept of reducing risk in portfolios that have experienced a sig-nificant  drawdown  has  critical  implications  for  the  entire  trading/invest-ment process, and I believe that it is perhaps the single most important dis-cipline  that  exists  in  the  field  of  risk  management.  To  understand  thisconcept  as  thoroughly  as  we  ought,  we  must  review  the  drawdowndynamic from the point of view of both the capital provider and the port-folio manager.
First,  from  the  perspective  of  the  entity  that  supplies  the  capital,  bemindful  that  due  to  the  everchanging  nature  of  the  financial  incentivesunder which portfolio managers may operate, their interests may divergematerially  from  yours  at  certain  thresholds  of  drawdown.  This  occursbecause portfolio managers, in a rational compensation system, draw thelion’s share of their financial incentives in the form of a percentage of theirprofits. In this way, under even modest levels of positive return, everyone’sinterests are properly aligned; and portfolio managers have every positiveincentive to manage their ongoing trading/investment activities in such a
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way  as  to  produce  the  maximum  risk-adjusted  return  that  is  available,given their trading style, market conditions, and other factors.
However, the same cannot be said for these interests when the port-folio in question is substantially in the red. In that case, the financial rela-tionship  between  capital  provider  and  portfolio  manager  undergoes  adramatic shift—primarily as the result of two factors. The first is tied to aconcept called high-water, which serves as the basis for remuneration forthe  majority  of  fund  management  enterprises.  Under  the  high-waterapproach, investment managers are paid their percentage cut only of therevenues  associated  with  net,  incremental  additions  to  the  value  of  theassets. For example, a trader who is entitled to 20% of the profits in a high-water payout regime and who loses, say, $1 million does not get his or her20%  of  the  revenues  associated  with  recovering  these  losses.  The  traderreceives the 20% only when he or she produces positive P/L above the$1 million. Traders who operate in deep deficit face the prospect of not get-ting paid for the revenues they generate until they have made back the fullmeasure of the losses they have suffered. Under these circumstances, theportfolio manager has a great incentive to minimize the amount of time ittakes to effect this recovery and has a tendency to believe (incorrectly, asit turns out) that the best means by which to accomplish this is by assuminga higher risk profile.
Second, capital providers tend to be very impatient with portfolio man-agers  in  drawdown  and  are  quick  to  withdraw  their  funding  in  favor  ofinvestment alternatives that offer better prospects. The associated risk offunding loss further incentivizes traders in drawdown to increase their riskto remove, with the greatest possible expediency, the condition that threat-ens their livelihood.
The confluence of these factors presents a potentially disastrous diver-gence of interest between the capital provider and the portfolio manager,as the former’s payout function is still “linear” (i.e., she derives essentiallythe same benefit from an incremental dollar of revenue as she does whenthe  portfolio  manager  in  question  is  flat  or  up  money),  while  the  latter’seconomics  are  “binary”  (i.e.,  he  only  gets  paid  on  an  upswing  in  his  P/Llarge enough to eradicate his deficit; otherwise he earns nothing and per-haps loses his funding to boot). Under these circumstances, the portfoliomanager has a very substantial incentive to seek out unacceptable levelsof  market  exposure  that  will  put  him  back  in  the  black  if  he  is  correctabout the markets but render him no worse off—economically or from acareer perspective—if he is wrong.
For  capital  providers  whose  objective  is  to  maximize  risk-adjustedreturn, there are few responsibilities more important than taking the stepsneeded to ensure that their portfolio managers in drawdown do not rampup their exposures. They must manage these responsibilities through the
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imposition of limits, the reduction of working capital, or any other meansavailable. Failure to take this step can lead to situations where, for obviousreasons, the losses associated with individual portfolios vastly exceed themaximum amount specified in the funding arrangement.
While the provider of capital has every incentive to ensure that portfoliomanagers in deficit don’t assume more risk than is dictated by their tradingcapital, he or she should not, as a rule, be averse to these traders using theirfull  risk  capacity  as  defined  by  the  Trading  Capital  Equation.  Once  theaccount is deeply in the red, so long as the portfolio manager is adhering tothe  disciplines  associated  with  the  10%  Rule  (or  appropriate  derivationthereof), the downside for the capital provider is capped with a reasonabledegree of certainty at the economic stop-out; and the risk/rewards associ-ated  with  the  portfolio  (so  long  as  it  exhibits  the  appropriate  exposurecharacteristics)  are  actually  no  worse  than  those  associated  with  posi-tively performing portfolios. In fact, they are arguably much better—due tothe high-water concept, under which any positive P/L generated by portfoliomanagers in drawdown falls directly to the bottom line—unfiltered by tradercompensation percentages that won’t accrue again for the trader until he orshe  has  made  back  the  loss.  Therefore,  unless  the  capital  provider  hasgiven up entirely on the trader in question (at which point the relationshipshould be severed, irrespective of current P/L considerations), he or sheshould  feel  very  good  about  funding  drawdown  portfolios—provided,again, that the portfolio manager is living within his or her risk limits andotherwise practicing sound risk management
However,  the  landscape  looks  vastly  different  to  portfolio  managersoperating  from  a  deficit  position.  As  we’ve  shown,  these  individuals  willface  significant  temptations  to  trade  their  way  out  of  their  losses  overshorter  time  periods  by  assuming  higher  levels  of  exposure.  I  will  arguestrongly that they should resist this temptation for the following reasons.First,  professional  portfolio  managers  who  take  pride  in  their  work  andwho  seek  to  earn  their  compensation  by  maximizing  risk-adjusted  returnunderstand intuitively that increasing their exposure from a deficit positionruns against the interest of their investors. Specifically, they recognize thatwhile they are, from a compensation perspective, no worse off if they losean  amount  equal  to  their  economic  stop-out,  or  an  amount  much  greaterthan this, their investors will feel this difference on a dollar-for-dollar basis.It can be hoped that at least a subset of professional money managers will,on  the  basis  of  pure  professional  pride,  resist  the  temptation  to  rapidlytrade out of any hole that they have dug for themselves by increasing theamount of market exposure they are assuming to levels that exceed or evenapproach the levels associated with the time period of the drawdown.
Second, the notion that it is in your interest to accelerate your recov-ery through higher risk assumption is entirely false. While such action may
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appear  to  work  to  your  benefit  in  the  short  term,  it  is,  on  the  whole,  anapproach  with  potentially  disastrous  career  consequences.  By  failing  toadhere to the disciplines of the 10% Trading Capital Equation, you show aninability (or, at minimum, a negative predisposition) to act in a manner thatis consistent with the critical principals of capital preservation and soundrisk control. True, the market may bail you out; and if it does, you may liveto fight another day. But even if this happy outcome becomes the reality, itcontains a much larger element of luck than may be apparent at the timeof  your  recovery.  Further,  there  is  probably  a  much  greater  chance  thatyour  additional  risk  assumption  comes  at  a  time  when,  viewed  from  anobjective perspective, market conditions don’t justify the additional expo-sure. After all, the only time when you are confronted with such an alter-native is after a serious episode of negative P/L, which in almost all casesis  symptomatic  of  unfavorable  market  conditions  or  less-than-optimaldecision making on your part, or some combination of the two. 
Ask yourself now, without the answer being clouded by conditions oftrading duress: Is this the time that you want to place the ultimate faith inyour ability to have identified sufficient market opportunities to justify anincrease in exposure? When viewed objectively, I believe that the answer,in almost all cases, would have to be no. 
Even if, in retrospect, the forces of nature combine in such a way as tohave  justified  additional  risk  taking,  my  experience  is  that  99.99%  of  thetraders  out  there  will  face  multiple  incidences  of  large-scale  drawdownsover the course of a career. If your response to each situation is to increaseyour risk as a percentage of trading capital, it is only a matter of time beforeyou experience not just a blowout, but perhaps a blowout of epic propor-tions. If you are managing other people’s money, it pays to be mindful thatthe  universe  of  potential  constituents  is  a  limited  one  and  that  they  arebecoming increasingly sophisticated in evaluating portfolio-manager reactionto conditions of performance duress. An incident in which you blew througha large portion of your risk capital and then lost more money through afailure to adjust your risk profile downward will be extremely easy to iden-tify and equally difficult to explain away. Any capital allocator who valueshis  or  her  job  and/or  wealth  will  avoid  these  types  of  portfolios  like  theplague.  For  self-directed  traders  funding  their  own  portfolios,  the  conse-quences of having luck run out at undue levels of risk, at a time when thesetraders are in the midst of a deep drawdown, should be only too obvious.
It is abundantly clear to me that from all rational perspectives, the onlyreasonable alternative for traders in drawdown/deficit is to reduce exposuredown to levels reflecting a fixed percentage of their trading capital. In addi-tion to minimizing the probability of hitting down-and-out thresholds, suchan approach virtually ensures that in instances where accounts do approachthese  thresholds,  they  can  be  liquidated  before  the  actual  loss  number
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exceeds the stop-out level by a meaningful amount. For the worst-perform-ing  portfolios  that  adhere  to  this  discipline,  the  P/L  path  approaches  thestop-out level in an asymptotic manner, with exposure decreasing at eachdownward leg of the P/L spiral.
The contrast associated with the approach of adhering to a fixed levelof volatility tied to trading capital, as opposed to one that does not adhereto  this  discipline,  is  depicted  in  Figure  5.1.  Believe  it  or  not,  I  drew  this
FIGURE 5.1 Time performance graph of effective and ineffective risk manage-ment performance.
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diagram myself, and I am immensely proud of my handiwork. If you everwant me to draw you a diagram, I’d be glad to try. Just don’t expect mira-cles like Figure 5.1, which only can be wrought from the artist through aprocess involving divine intervention.
In addition to its indisputable aesthetic merit, Figure 5.1 is instruc-tive  from  a  risk  management  perspective  as  well.  As  can  be  seen,  thethin-line portfolio is one where the trader sets an upper bound of expo-sure as a reasonable percent of trading capital. When this account expe-riences a deep drawdown, it removes risk in an orderly fashion and, inthe process, ensures that the loss does not violate the stop-out thresh-old.  The  thick-line  portfolio,  by  contrast,  is  one  where  risk  does  notadjust  downward  with  negative  P/L  but  instead  stays  constant  orincreases over the course of the drawdown. Here, as can be seen, thereis  virtually  no  limit  to  the  amount  of  loss  the  portfolio  can  ultimatelyexperience; and in many cases the actual figure will exceed the associ-ated down-and-out by material amounts. If you buy into notions regard-ing the sanctity of the economic stop-out threshold, then I am sure you’llagree that the best means of controlling your exposure is to stick to thedisciplines that derive from operating within the framework specified inthe 10% Equation.
Adherents  to  these  principals  must  be  mindful  that  maintainingmaximum  risk  capacity  as  a  fixed  percentage  of  available  tradingcapital—particularly during periods immediately after intervals of deepdrawdown—is  one  of  the  most  difficult  tasks  I  know  of  in  the  field  ofportfolio management. In more cases than not, and particularly for thosewhose drawdowns take them deeply into a negative P/L position (i.e., asopposed  to  ones  that  merely  reduce  accumulated  profitability  for  theperiod), such a commitment means a willingness to invest meaningfullylong time periods to the recapture of P/L for which, due to the high-waterconcept described earlier, there is no attendant compensation. And if thisprospect weren’t unpalatable enough on its own, it is my observation thata  commitment  to  operate  at  reduced  risk  levels  in  the  wake  of  a  draw-down will often coincide with periods of large perceived opportunity inthe markets that comprise a trader’s core focus. Indeed, even if this isn’tthe  case,  from  the  perspective  of  the  trader,  it  almost  always  seems  asthough it is.
Finally, as you begin to recover your losses, there will be a significanttemptation to view the problems that caused the drawdown as an anom-aly that is not likely to repeat itself and to accelerate your assumption ofexposure  at  a  rate  faster  than  is  specified  by  the  10%  Trading  CapitalEquation. I urge you to resist these forces, as the manner in which youdeal with them may, in my estimation, have a substantial bearing on yourfuture career prospects as a trader/portfolio manager.
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Inevitably,  the  voices  inside  your  head  will  begin  to  tell  you  the
following stories:
• The  episode  of  your  recent  (albeit  partial)  recovery  offers  incontro-
vertible evidence that your problems are behind you.
• Great trading/investment opportunities exist right now; but they maydisappear—perhaps  for  good—by  the  time  you’ve  accumulatedenough risk capital to take full advantage of them.
• At current risk levels, your trading compensation prospects are unac-ceptable and are likely to remain so for an unacceptably long periodinto the future.
When you combine all of these arguments, they make for a compellingcase to increase your exposure as quickly as possible now that happy daysare indisputably here again. However, you increase at great peril to yourlong-term prospects for the simple reason that if your fortunes take a turnfor  the  worse  at  this  critical  juncture,  the  results  can  be  devastating.Depending  on  how  much  incremental  risk  you  have  taken  on,  you  standevery chance of taking your portfolio values to new lows. If this happens,it may wreak considerable havoc on your confidence as well as on the con-fidence of those who own the capital you are managing. Often this pheno-menon can cloud your ability to make sound market decisions (after all,you are now wrong twice: first, on the original drawdown, and second, onyour ramp-up), which can severely hinder your ability to make money evenunder  favorable  market  conditions.  By  contrast,  if  you  have  maintainedyour exposure as a fixed percentage of your trading capital, you have bothlimited your risk on the downside and ensured that even if you miss a fewgood  opportunities,  you  have  nevertheless  demonstrated  the  ability  tomanage your exposure effectively under times of duress. Under these cir-cumstances, you stand to have a long, satisfying career as a trader, instill-ing  yourself  with  confidence  and  increasing  the  trust  in  your  judgmentamong  those  who  are  impacted  by  your  trading  fortunes.  In  the  end,  Ibelieve this is well worth the investment you make by resisting the temp-tation to increase exposures beyond those that tie back logically to yourcapacity to absorb losses.
BORN TO RUN
Let’s take a brief journey into the world of our imagination, where there existsa land, located in a deep hole somewhere in the middle of the wilderness, inwhich everything a trader looks on is higher than he or she is. I refer, of course,to the Kingdom of Drawdown. It is a very drab, tedious place, where visitors
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always appear to be in a great hurry to leave. In fact, some might go so far asto call the Kingdom downright depressing. Certainly no one who visits is eververy  happy,  and  the  permanent  residents  are  often  described  as  the  walkingdead. Indeed, I have often wondered what it is about Drawdown that makes itso  popular,  with  traders  of  every  level  of  skill  visiting  there  routinely  and  itsregister of full-time residents increasing each day. In terms of its topography,the Kingdom of Drawdown looks much like New Jersey, with the same size andshape  but  without  the  Bruce  Springsteen  affiliation.  In  fact,  its  main  trans-portation artery is a near-perfect replica of the New Jersey Turnpike, with a toll-based structure under which the deeper into Drawdown you travel, the higherthe toll you are forced to pay at the end of your journey.
Although it is a Kingdom, Drawdown has no king. Instead it is ruled by twoaristocratic fellows who wear plumed, festooned garments and who make sure,through their sheer nastiness, that no one ever has a good time on their watch.One  is  the  Duke  of  Risk  Reduxus,  whose  job  it  is  to  make  sure  that  no  onewithin the Kingdom walls goes too fast on the turnpike (he is rumored to havesocialist leanings). His partner (said to be related to the Duke by blood or mar-riage) Count Compus Interuptus, runs the turnpike toll booths and spends hisdays making sure that he grabs every last available shekel that the good citi-zens could muster through their labors.
Our tale takes place in the infamous third quarter of 1998, which was a veryimportant period in the Kingdom’s history, as those who were there can verify.Drawdown was in fact very crowded that Indian Summer (by many accounts, thisis  the  peak  of  their  tourist  season),  playing  host  to  many  of  the  world’s  besttraders—many of whom were unfamiliar with its terrain and each of whom waseager to make the visit to the Kingdom as short as possible. However, with somuch traffic on the turnpike and with the Count’s henchmen waiting to collecttheir fees, it was very difficult to get out; and the scene of untold numbers oftraders and investment managers, each carrying the baggage of large portfoliosand each desperately trying to return home, was one of the saddest that thisreporter  has  ever  had  the  responsibility  to  describe.  Gradually,  an  idea  arosefrom  the  multitudes,  an  inspiration  of  sorts:  Each  of  them  could  individuallyincrease their speed by traveling lighter. Though there was scant communica-tion among them, they decided that the best way to proceed was to shed theirportfolio  baggage.  So  they  hurried  to  the  market  village  of  Drawdown  (whichwas  way  down  around  Exit  9),  seeking  to  liquidate  their  holdings  at  the  bestprice they could. Unfortunately, the merchants of the town had a keen eye forvalue, and all of the traders were pretty much selling the same wares. Naturally,prices plunged dramatically, and many traders had to travel out of the marketvillage, ever deeper into the Kingdom, to find buyers for their wares. Moreover,at  the  rate  at  which  their  portfolios  were  being  liquidated,  it  was  becomingincreasingly clear that many traders would not be able to raise the exit toll andmight be stuck in the Kingdom of Drawdown forever.
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One of the groups that participated in this sad pantomime was a companycalled  Jai  Lai  investments,  a  very  well-known  and  well-thought-of  enterprisethat  hadn’t,  truth  be  told,  spent  much  time  in  Drawdown,  instead  managingbrief and infrequent stays over a long history. Jai Lai had two traders who wereleading the expeditionary team at that time, known respectively as Doofus andRufus.  These  two  were  boyhood  pals  and  virtually  inseparable  from  the  timethey first swapped football cards in the 1970s. As trading partners, they hadmade a great deal of money together, and they were very much taken by sur-prise when the world turned upside down in the fall of 1998. However, theirresponses to these episodes were very different. Doofus was Jai Lai’s special-ist in charge of trinket collection, and what a job he did! In the years before ourstory  began,  he  had  accumulated  such  an  assortment  of  knickknacks  andthingamabobs as to leave the average observer plainly speechless. There wereenough Peruvian Pelts and Turkish Treasures to make your eyes water. Therewere baubles from Brazil, Danish pastries, Malaysian mish mosh, Venezuelanvictuals, and even some stuff from places no one had ever heard of before. Oh,Doofus was very proud of his collection and, being a bit mercurial by nature,entered Drawdown with something of a haughty attitude. His pantaloons wereflush with drachmas, pesetas, rupees, and even some dollars at the time; andhe wasn’t particularly concerned about hanging around the Kingdom for a bit.He figured he was driving a Ferrari on a road full of Chevys and could burn hisway up to the exit booth pretty much any time he so chose. As the winds blewcolder, he began to notice heavier traffic on the turnpike, but he wasn’t overlytroubled by this trend. Moreover, he had no inclination of any kind to reducehis  collection  of  odds  and  ends  (which  had  taken  years  to  accumulate)  atwholesale prices to facilitate his departure.
In fact, being a natural-born contrarian, he got the very clever idea of buy-ing  when  his  colleagues  were  selling;  and  the  sight  of  him  bidding  with  thelocals against his trader buddies is one that few who witnessed it are likely tosoon forget. Of course, the selling pressure turned out to be so intense thatafter a while, even Doofus couldn’t stem the drop in prices. As this happened,Doofus sold everything, including his Ferrari, at bargain-basement rates; andin the late stages of this process, he could be found not near the exit gates orin  the  market,  but  rather  sitting  on  a  park  bench,  legs  crossed,  reading  theDaily Mail. In the end, his entire stake was wiped out. And the really sad thingabout this is that by all accounts had he been selling with everyone else in theDrawdown  market  square  instead  of  buying,  he  likely  could  have  raised  thecash  to 