Days 2/22/88• 6/20/95

Figure 6.12 Equity curve for CT using the 65sma-3cc system.

two markets were independent, then their variances (squared standard error) would just add up linearly. This indicates that the expected value of the standard error for the joint CT + DM equity curve is $5,098. However, we see that the actual value is slightly higher, at $5,264, imply­ing some positive covariance. Thus, we could not have reduced equity curve roughness by combining these two markets. We can show that adding more markets to a portfolio does not increase smoothness (re­duce SE) unless the two markets are negatively correlated. Usually, there is some weak correlation between markets due to random or fundamen­tal factors, and markets rarely move exactly opposite to each other. Hence, we should expect roughness (or SE) to increase as we combine the equity curves from different markets.

In summary, the SE of the equity does not automatically decrease when you change exit strategies, combine different systems on the same markets, or combine different markets on the same system. However, changing entry strategies can change SE significantly. This conclusion goes a bit against the popular wisdom that "diversification" gives a smoother equity curve. Diversification in this context means trading

194 Equity Curve Analysis

Equity for joint CT + DM using 65sma-3cc and $5000 stop

Days: 2/22/88-6/20/95

Figure 6.13 The joint CT + DM equity curve.

many different markets with the same system, or the same market with many systems. Of course, we are measuring the smoothness using the standard error from linear regression analysis. We saw in the previous section that increasing the slope does not reduce the SE.

You should use the information in this section to understand how system design and portfolio strategies can affect the smoothness of your equity curve. In this section we examined the daily equity curve for indi­vidual markets or systems. In the next section we look at the monthly equity curve and how it changes with money-management rules.