Trading Systems and Methods, + Website, 5th Edition

Preface to the Fifth Edition

In the past eight years, since the last edition, our industry has continued to change. The extraordinary bull market of the late 1990s, followed by the bursting of the tech bubble in 2000 seemed to be events that could never be overshadowed, but the subprime collapse in 2007 proved us wrong. We learned what risk was all about, when money was pulled from every possible investment at the same time. In many cases, the investments that were liquidated had no other relationship than having profits that were needed to cover losses elsewhere. The principles of diversification held true, but we saw the worst-case scenario, where everything moved in the same way at the same time. It was an event with a very low probability, but not zero.

During the years that have followed, we would expect much more focus on risk management, rather than risk measurement. Understanding how to reduce risk before the fact is much more productive than identifying it afterward. Some hedge funds, following in the steps of Long-Term Capital Management, have chosen to see this as a rare event, not likely to be repeated. The rationale for this is that, in order to reduce the chances of large risk, you must also reduce returns. They see investors as preferring the small chance of a large loss to the less acceptable assurance of lower profits. I won't try to judge the merits of this decision.

On the other hand, we should all understand the best choices for controlling risk. With that ...