That is almost certainly true in the high frequency trading arena where an individual has no chance against a well capitalised HFT firm, but not in the sorts of systems that I trade (holding periods averaging weeks or months).
That's a very good question to ask, but I don't need to be better than the hedge funds, I just need to be better than the market on average, as long as I stay away from the areas where they definitely have an advantage.
I think that true trading skill is rare, and thus most people are better off with mechanical rather than discretionary systems [although there are some exceptions as I discuss here]. You are probably an exception to that rule, but I am not: I have probably made a good discretionary call four times in the last 15 years, which isn't enough times to prove anything; and certainly isn't enough to make a career out of.
However, I do think that individual traders do have some advantages over institutions even when running systematic strategies (freedom from 'style boxes', ability to run more diversified portfolios where capital allows, less brain suck from non productive activities like compliance). My own performance has been pretty competitive with the large funds in my particular slice of the industry.
OK I agree with this: Mathematically, your drawdown is a product of your leverage and your risk adjusted return (Sharpe Ratio). Double your leverage, and for a given underlying Sharpe Ratio you will double your expected drawdown. For any sharpe ratio there is an optimal leverage of leverage (the infamous Kelly criteria) that will optimise your geometric returns and final wealth, so you can restate this as an optimal level of leverage.
And you're right that most institutions run at risk which is well below what Kelly says they can do. For example, a world leading hedge fund that runs at a Sharpe Ratio of 1.0 can theoretically run at 100% annualised risk, which would mean some pretty hefty drawdowns. But most run at less than 50%; and for some types of relative value funds it can get down to 10%.
[If I take my own trading account for example, my risk target is 25% a year which is higher than most institutions, and I've encountered a maximum drawdown of 17% in live trading over just under 7 years. If I look at the backtest then the drawdowns are bigger]
And you are right, that some of that is down to client appetite [although more sophisticated clients prefer higher risk targets, since it makes for fairer fee structures]. But it's also because institutions recognise that a theoretical result is exactly that - theoretical. And there are a thousand reasons why you shouldn't use as much leverage as theory says.
And it's much better to use too little leverage rather than too much. For example, if my optimal leverage gives me an expected (geometric) return of 25% a year, then using half of that would give me 18.8% a year; not as good but still pretty good. But if I use twice as much as the optimal leverage then my expected return is.... zero. Using any more and I'd be expecting to lose money.
I'd argue that the vast majority of retail traders are running at risk levels well beyond what even is theoretically optimal, because they're vastly overestimating their likely risk adjusted profitability.
So I don't think that the ability of retail traders to stomach more risk than institutions is an advantage. Given that the average retail trader is much much worse than the average institution in terms of risk adjusted returns, if anything they should be using even less risk than the institutions are.
GAT
