Investing Into Drawdowns

Most investors want to invest in strategies that have experienced the strongest recent performance, a phenomenon known as 'performance chasing'. As such, these investors extrapolate recent performance with the expectation that it will continue. This strategy results from a common behavioral bias for investors and is often the wrong approach. After hot streaks, strategies can loose steam and experience mean reversion of performance by entering into drawdowns. A drawdown is a peak-to-trough decline during a specific investment period.

What if we took the opposite approach? Instead of trying to chase performance, an investment could be made during a drawdown to attempt to capitalize on mean reversion in performance. During drawdowns, the natural inclination for most investors is to question the viability and efficacy of the trading systems. Although its not a natural tendency to want to increase your investment while a strategy is underpeforming, it can be a very effective investment strategy. Examining the monthly performance of the Algorithmic Future systems, there are many times months with negative performance are followed by very strong performance.

There is much research exploring this topic that provides evidence to show the odds of making a positive return after a period of negative performance are higher than after a period of positive performance. Most notably, the research paper by Tom Basso titled "When to Allocate to a CTA? - Buy Them on Sale" provides evidence of this strategy. While this is not always the case, investing in drawdowns can be a good strategy to allocate capital and increase trading units to benefit from mean reversion of drawdowns.