 Welcome back to the Trade Hacker Mindset. In this episode, I want to talk to you about how to diversify using compound annual growth versus max drawdown. Trading the markets can be difficult to master and seemingly just out of reach. Professional traders have a secret. Trading requires total mental and emotional control. It requires the Trade Hacker Mindset. All right, so let's jump into this discussion of how to diversify your trading with using the statistic, performance statistic, compound annual growth, also known and shortened as CAGR, CAGR, versus drawdown or max drawdown. So one thing that, and I've tried to talk about this within the community, I'm not sure I quite articulated it good enough. So hopefully this will provide some of you with a little bit of an aha moment when it comes to, when you're doing testing, specifically backtesting on some of the strategies that you plan to trade. By the way, Option Omega, amazing backtesting tool. If you don't have it, I've gotten to know the owners, great guys, and they've been generous enough to give our community 50% off on their backtesting software. You can go to navigationtrading.com slash omega to check that out. So when you're doing your testing, there are several statistics that you want to pay attention to, one of which is CAGR or compound annual growth. So in addition, just to seeing, okay, here's the P and L that the test made over a specific period of time, the CAGR will show you what the annual, projected compound annual growth for the variables that you put in your test. The other important one is max drawdown, right? So that is what was the max drawdown on a percentage basis that you saw in your account value over that period of time in the backtest. And then kind of a combination of the two is what they call MAR ratio, which is basically just taking the compound annual growth divided by the max drawdown. Of course, win percentage, all those things are important as well. But what I want to focus on today is looking at and trying to rationalize in your mind when you're choosing different strategies, how to use compound annual growth and how to use max drawdown. So if you think about this, and let's just simplify it, I'm not talking about any specific strategy, I'm just going to use round numbers to help hopefully articulate something that is important to understand when you're looking at these performance statistics. So let's say, for example, you have two different strategies that you are looking to trade, okay? And one strategy has a compound annual growth rate of 10% a year, okay? Again, just using simple round easy numbers to do math with, right? So you have a one strategy that makes a compound annual growth of 10% per year and you have another strategy that has a compound annual growth of 15% a year, okay? So let's assume that these two strategies are uncorrelated, okay? And let's say that you're going to put the same amount into each strategy. So you're going to put 50% in the strategy that has a cagger of 10%, you're going to put 50% of your allocation into the strategy that has a 15% compound annual growth rate, okay? So if you do 50 and 50, assuming these are uncorrelated strategies, what you will find is that your combined compound annual growth rate is the average of the two, right? So if you get 10% in one, you get 15% in the other, average those together, your combined portfolio would have a compound annual growth rate of 12.5%, okay? Pretty simple. I don't think that comes as a shock to anyone. But here's where things get a little bit interesting. If you look at the drawdown, okay? Which is important, right? That's what helps us sleep at night. That's what makes our P&L, our equity curves a lot smoother. You're not having these roller coaster up and down P&L swings. So the drawdown is a good measure is a good tool, good statistic to measure the volatility of your portfolio. So let's use the similar numbers. So what if those same two portfolios, the one that had a 10% cagger and a 15% cagger, where your combined average is 12.5% on your compound annual growth, what if we looked at the drawdown for those exact same two and let's say we use the same numbers, let's say the one has a drawdown of 10%. And the other has a drawdown of 15%. Well, you might make the mistake of thinking that it works the same way on the downside, which is, well, if one has a 10% drawdown, one has a 15% drawdown, just average those together. So my average drawdown, if I put 50% in one and 50% in the other, both of these are uncorrelated, then my drawdown, my average drawdown between the two would be 12.5%, right? That's actually not correct, okay? Because they're uncorrelated portfolios and you're combining them together, what you're going to find is that the average, the drawdown of your entire portfolio between the two, where one has 10, one has 15, you're actually going to see a combined drawdown of less. Okay, now, this is where details come into play of specifics about the portfolio, but you could see a combined drawdown of more like seven or 8%, okay? So that's how the math works. So on the compound annual grace, you just growth, you're just taking the average of the two caggers, but on the drawdown, because of the diversification you're getting between two uncorrelated strategies, your drawdown is actually not the average between the two, it's actually less. So using these kind of simple numbers, you could see that if one had a 10% drawdown, one had a 15%, your overall drawdown from your portfolio could actually be around seven or 8%, okay? So that should kind of help in your mind, at least give you a picture of A, and we all know this, you've heard since you were two, when it comes to investing, don't put all your eggs in one basket, right? Diversify, and so this is a way of kind of quantifying that. Now, when you go in to do your own testing, and you can do these measures with compound annual growth and allocation and max drawdown and all the different things, but this will help you understand that how diversification can be a very powerful thing. You may have a very popular, you can probably find this on YouTube, but Ray Dahlio, one of the largest hedge fund managers in the world, I remember seeing a video of his talking about diversification and talking about what he called his all-weather portfolio and how the drawdown and the standard deviation or the volatility of the portfolio, how it was significantly reduced by just simply adding in uncorrelated diversified assets. He talked about put a certain amount, a certain percentage in stocks and a certain percentage in bonds and a certain percentage in commodities and real estate and cash and that kind of thing and what that would do to the volatility of the portfolio. This is the same concept. The difference is we're active traders and we are actively trading different shorter duration strategies, but the concept is the same. And the concept is and why we talk about not focusing just on one strategy and diversifying into multiple strategies. What we like to see is we like to see entering positions that have positive Vegas. So they benefit from implied volatility expanding and we have strategies that benefit from implied volatility contracting and we're constantly layering into those positions at different price points, different price levels, different durations and by doing that, we are reducing our overall volatility of our portfolio. We're reducing our overall max drawdowns and it's just a very powerful thing that you need to be aware of when you are creating your trade plan for the strategies and the methodologies that you're gonna be trading. Now, when it comes to option Omega and doing this testing, one of the most powerful things that they have put into the software is the use of portfolios. So you can run individual tests on different strategies, but then you can also combine those tests into one portfolio and see what the statistics are from a compound annual growth rate from the max drawdown standpoint on those strategies when you put them together. So if you've done this before and you were surprised that you had these individual strategies with these individual drawdowns, max drawdowns and then you put them together in a portfolio and realized, huh, my drawdown's actually less by simply combining these diversified uncorrelated, somewhat uncorrelated portfolios. So it's a pretty powerful tool. I just wanted to try to put this out there in hopefully a semi-clear, well-articulated way so that when you are doing your testing, you kind of pay attention to that and understand the power of diversification based on these metrics. Hope that helps. See you in the next episode.