Money matters

Price shocks represent the most significant obstacle in the effort to close the gap between test results and actual trading, or expectations and reality. A price shock is, by circumstance, an unexpected event. Exceptionally volatile price moves are caused by actual news that differs from expectations, such as the Fed raising rates by 1% when only VA was anticipated; or, it may be a significant, unexpected political event, such as the abduction of Gorbachev in 1991. The key word to remember is “unexpected.”
If an event was expected, then there would be no price change. The market would have already moved to the anticipated level. Therefore, we cannot expect to profit from a price shock by clever planning, but only by chance. We should never assume that we would be on the right side of a large, unexpected move in more than 50% of those events. Unfortunately, when we back-test a trading system using historic data, we tend not to identify specific price shocks and treat them as normal, predictable events. We choose systems that perform best over a set of parameters, without regard to specific trades that may have been the result of shocks. We judge results by higher profits, lower risk, or a combination of statistical values. The results chosen as the best performance often have been the greatest beneficiary of these unpredictable price shocks.

Business risk is the uncertainty of income flows caused by the nature of a firm’s business. The less certain the income flows of the firm, the less certain the income flows to the investor. Therefore, the investor will demand a risk premium that is based on the uncertainty caused by the basic business of the firm. As an example, a retail food company would typically experience stable sales and earnings growth over time and would have low business risk compared to a firm in the auto industry, where sales and earnings fluctuate substantially over the business cycle, implying high business risk.