Flaw of Averages by Sam Savage

I recently finished “The Flaw of Averages” by Sam Savage on a recommendation from a great blog by Nick Gogerty, Designing Better Futures. I thought the book to be an excellent read, in fact I devoured it! However I was somewhat disappointed that the material did not go into greater technical depth and into more specific examples of uses for Probability Management.

The books spends most of its time explaining how everyday assumptions on the use of averages is a failed and biased estimator. Remaining chapters explain usage of probability distribution functions to model potential portfolios so one has a more realistic idea of a the ‘range’ of probable outcomes as opposed to one outcome with very low statistical chance of actually happening.

For example, when we create a back test and look at the created equity curve, a common error is to extrapolate this curve forever into the future. But lets say we’re smarter then that and we know at some point that this strategy will stop working, so we look for methods to identify when or how this strategy will become kaput. More importantly, what we should have done is looked at a number of various scenarios of that same equity curve. Had we performed optimization, and I’m pretty sure we did, we should construct equity curves for all possible parameters. We should look at equity curves where we take out the best months, best trade, best week, etc. to create a pessimistic rate of return. We should do everything we can to come up with a ‘range’ of equity curves:

If we are happy with our range and we are ‘lucky’ then our performance should be near the top end of the range however we should also be ready and accept the less palitable lower range as well.

But this is a digression, the book is a great read especially for those new or rusty in the area of statistics. I would hope that a reader or someone could recommend a good statistcs book that can be related to more high frequency trading strategies and statistical arbitrage.

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~ by largecaptrader on August 17, 2009.

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