Automated Trading and the Risk of Catastrophic Loss
Automated Trading systems have some big advantages over other investments: they require little time to maintain, they can be less volatile than buy-and-hold strategies, and can even provide high rates of return. That makes some people think that they are a silver bullet for investing.
We think that they are great, and they have one risk that some other investments don’t have. That is the risk of catastrophic loss, or losing all the money in the account. Because once the money is gone, it’s over.
Why don’t some investments have this risk?
There are some other investments that don’t have this risk because of low leverage. If you buy an index fund, we can be pretty certain that the index will not go down to zero. It can go down 50%, 60%, or even 90%. But we really don’t have to worry about it going to zero.
Other investments like CDs and saving accounts have very little chance of catastrophic loss. If they are insured by the government, then in theory they will be fine as long as the government is OK. Right now, that is a good bet. But we are not sure what the future holds.
Just because Automated Trading systems have this risk does not mean that they are not useful to us as investment vehicles. We only need to understand and mitigate this risk in order to make sure that we don’t get surprised later.
How can we mitigate this risk?
One way is through analyzing the risk reduction strategies of the Automated Trading system. There are many ways that the developers can reduce the risk of loss in these systems. One way is through using a trailing stop loss. Another is through trading multiple assets and portfolio diversification. Another way is to trade assets that are not strongly correlated.
A second way to mitigate risk is to understand the shortcomings of backtesting. Many Automated Trading systems are developed through backtesting, which means that the computer creates systems that would have done well in the past. However, this does not mean that the systems will do well in the future. Therefore, using systems that have been developed through backtesting without further enhancement may not be a great idea.
Just as in life, there are no guarantees in investing. However, if the developers are aware of the risk of catastrophic loss and work hard to mitigate this risk, then the systems will probably do well. We cannot be sure about what will happen in the future, but if the system has been designed with risk reduction in mind, then it will probably do better than systems that ignore risk.
Related posts:
- Automated Trading and the Value Investing
- Automated Trading and Economic Recovery
- Automated Trading and Risk Management
- Automated Trading and Futures
- Automated Trading and Index Funds
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