The equity curve visually illustrates the ups and downs of your investment account value over time, and you can see what it looks like in the top pane of Chart 1. It is one of the first things we look at when evaluating the performance of an investment or trading strategy, because its visual nature delivers information that no other performance numbers could easily match. Ideally, you want the equity curve to go up at about 30 to 45 degree angle and be as smooth as possible, since rough equity curves are tough on the nerves.
Unless you’re looking at an overall losing strategy, the equity curve shows you what you could have made, or the “reward,” so to speak. That’s just half the story, and looking at it alone is like looking at all the nice features of a shiny new car in the showroom without ever asking about the price. The other half of the story, of course, is risk.
The underwater equity curve visually illustrates the drawdown, which is simply the amount of money lost from the highest equity peak. It is usually expressed in percentage terms, as you can see at the bottom of Chart 1, but it’s not unusual to see it in dollar terms either. It is also one of our favorites to look at in a strategy, since it captures risks in a way that no other risk measure can. Ideally, you want the underwater equity curve to be non-existent, but of course, that’s not realistic. A more practical approach is to look for strategies that have less than 25% drawdowns, and only in brief periods. Strategies with large or long-duration drawdowns are psychologically difficult to follow.