Best of TTU – From Discretionary Trading to a Systematic Approach

At the very beginning of my podcasting career, I had a great conversation with Mike Dever covering many trading related topics, one of which were the different approaches to trading. And there was One segment I really liked in particular, and which I would like to share with you today.  It was a segment where Mike shared his own systematic approach to trading and as you listen to it, we need to keep in mind that Mike was not always a systematic trader.  If you would like to listen to the full conversation just go to top traders episode 3 and Episode 4.
From Discretionary Trading to a Systematic Approach
Niels: And the Benchmark program, was that systematic and completely without discretion? Or did you keep sort of your discretionary trading in there?

Mike: No, we didn't. It was fully systematic. But what we did was look at a lot of types of trading that I did through the '80s and try to capture that in a systematic fashion. So, for example, we had a number of strategies that were based on market reaction to news events or reports. Because I traded a lot of that type of event reaction in my discretionary trading.
So, we systematized the approach, captured it in the best way we possibly could and included that in the Benchmark program. So, there were a number of strategies in Benchmark that were based on sort of that intuitive or discretionary feel.

"We had a number of strategies that were based on market reaction to news events or reports "

But instead of relying on the black box of the brain to interpret everything correctly each day, it followed a rigid set of rules to be able to repeat the process every time it reoccurred.
Niels: And so, in that sense, just to be clear, were you convinced, even at that time early on, that if you were going to be successful from an investment management point of view, you had to be systematic? Was that something that just was obvious at that time? Or was it more of an operational issue where you say "Okay, it's actually easier if I can do it systematically."
Because the systematic side of things is partly, I think, an operational issue, but it's also an emotional issue, in my opinion.
Mike: Absolutely. The one thing you get from systematic...the one main thing I think would benefit the majority of traders out there is the discipline that it brings to the trading. You can sit there and say as much as you want as a discretionary trader "I'm going to cut my losses at these levels, I've got a bad trade, I'm going to get out when it does this."
But not everybody does that. And you may do that for a while, but at some point, there's that constant battle where you're sitting there saying "But it's a great position. I've got a great position."
And I've been reading some books about the financial crisis. And one the things that you see there that's the same as what you had with long-term capital, is just that utter breakdown in risk management discipline. And it's easy for a person to sit and rationalize why "You know what? The risk management wasn't designed for this scenario." Or "This was a great trade 10% loss ago. It's even better now." So, I'm certainly not going to get out of it today and just ride it into the ground. So, the one thing, if there's nothing else that you get from systematic trading, is the disciplined risk management approach to trading.

Related to risk management comes draw downs. I'd love to know how you or whether you do predict in your testing and analysis a level of expected draw down for the way the portfolio operates. Is that how you come up with the overall balance to say, "We're happy to do this, because we expect it to have," as you say, "a certain level of return, a certain level of standard deviation?" I don't know whether you relate that standard deviation to draw downs as well or how you look at that.
Mike: Yeah,