Consider two situations:
A trader starts with a million in his hands. He enters the market at a good time and, in the next three years, reaches a position valued at 50 million. After which, a recession hits, and his position is reduced to 5 million in another 2 years' time. He now exits his position. In 5 years, he made 4 million, a cool 400% return.
Now consider another (counter-cyclical) trader, who starts with the same 1 million. After 3 years, his position reaches a valuation of just 10 thousand. He recovers in the next 2 years, and ends up with a position valued at the same 5 million.
I recently finished reading 'Fooled by Randomness', and Taleb describes a situation very similar to the above in that book. I have two adjectives for the guy, arrogant and genius, in that order.
But the question he raises is whether these two 400% returns are equal? Clearly not! Even if these paths are equally volatile, these returns are not the same. Conventional risk-adjusted return measures do not work here. Even ratios which aim to distinguish between upside and downside deviation (like sortino) are not much of a use. The problem here is more behavioural, and the way they perceive their returns.
The first trader will always think of his experience with regret and sorrow. He will keep thinking how great it could have been, had he exited at the peak. Because he perceives it as a missed opportunity, he will underrate his return. The opposite is true for the other trader. He will be a lot more satisfied with his return, and he will perceive this return to be more than the actual value.
It is this difference in perception that I want to capture with a number. I suggest the following:
Regret ratio = (Maximum Valuation - Ending Valuation) / (Ending Valuation - Minimum Valuation).
This ratio should work very well in all those cases where the return is positive during the complete 5-year period. I do not intend to measure regrets when the total return during that period was anyway negative.Hence, it is a non-negative number.
The numerator here is essentially a measure of the feeling of regret with the experience. The denominator measures the opposite feeling of satisfaction or good luck with the experience. Their ratio should denote the net effect of regret from the experience. The higher this number, the larger is the feeling of regret. The smaller this number, the more the person gets a feeling of satisfaction.
A trader starts with a million in his hands. He enters the market at a good time and, in the next three years, reaches a position valued at 50 million. After which, a recession hits, and his position is reduced to 5 million in another 2 years' time. He now exits his position. In 5 years, he made 4 million, a cool 400% return.
Now consider another (counter-cyclical) trader, who starts with the same 1 million. After 3 years, his position reaches a valuation of just 10 thousand. He recovers in the next 2 years, and ends up with a position valued at the same 5 million.
I recently finished reading 'Fooled by Randomness', and Taleb describes a situation very similar to the above in that book. I have two adjectives for the guy, arrogant and genius, in that order.
But the question he raises is whether these two 400% returns are equal? Clearly not! Even if these paths are equally volatile, these returns are not the same. Conventional risk-adjusted return measures do not work here. Even ratios which aim to distinguish between upside and downside deviation (like sortino) are not much of a use. The problem here is more behavioural, and the way they perceive their returns.
The first trader will always think of his experience with regret and sorrow. He will keep thinking how great it could have been, had he exited at the peak. Because he perceives it as a missed opportunity, he will underrate his return. The opposite is true for the other trader. He will be a lot more satisfied with his return, and he will perceive this return to be more than the actual value.
It is this difference in perception that I want to capture with a number. I suggest the following:
Regret ratio = (Maximum Valuation - Ending Valuation) / (Ending Valuation - Minimum Valuation).
This ratio should work very well in all those cases where the return is positive during the complete 5-year period. I do not intend to measure regrets when the total return during that period was anyway negative.Hence, it is a non-negative number.
The numerator here is essentially a measure of the feeling of regret with the experience. The denominator measures the opposite feeling of satisfaction or good luck with the experience. Their ratio should denote the net effect of regret from the experience. The higher this number, the larger is the feeling of regret. The smaller this number, the more the person gets a feeling of satisfaction.
