Thursday, February 28, 2008

MarketPsy Capital

Our new spin-off asset management firm, MarketPsy Capital, was mentioned in a new Popular Science Magazine article. The fund will be using our ground-breaking linguistic analysis technology to identify and exploit psychological mis-pricings in stocks, currencies, and commodities. For more information, please contact Richard Peterson at [email protected].

Tuesday, February 12, 2008

Rogue Trader Psychology: What Makes Them Tick?

"You have to have men who are moral... and at the same time who are able to utilize their primordial instincts to kill without feeling... without passion... without judgment... without judgment. Because it's judgment that defeats us."
Dennis Hopper playing Kurtz, in "Apocalypse Now!"

"You show them you have in you something that is really profitable, and then there will be no limits to the recognition of your ability."
Kurtz, the original rogue trader, in "Heart of Darkness" by Joseph Conrad.

With the loss of $7.5 billion by Societe General trader Jerome Kerviel, speculations about the psychology of rogue traders is in the news. How could one person end up losing so much of someone else’s money?

The psychological factors cited to explain Kerviel’s misdeeds range from the redundant (“he wanted to be a great trader”), to the fatalistic (“some people can’t help themselves”), to the pop psychological (“he was born provincial and wanted to prove himself as one of the elites” – see the WSJ), to the ultra-modern (“his brain is wired differently”). See Frank’s excellent CNBC “Closing Bell” appearance on February 7, 2008 for more about the brain and hard-wired “risk-seeking errors.”

I don’t know Kerviel, and even if I did, I wouldn’t speculate about his psychology. (Frank didn’t speculate on CNBC either, instead he mentioned some common brain-related investing errors).

Don’t get me wrong, speculating can be useful if it helps to establish the “profile” of rogue traders. And there have been some decent attempts in this regard. Financial firms, and their HR departments, have a vested interest in preventing the losses of billions of dollars because the proverbial mail-boy had "a hunch." Thus they use every psychological screening tool available to find and weed-out potential rogue traders.

Besides the obvious disqualifications for a trading job (a stint in prison, repeated personal bankruptcies, frequent stays at a high-rollers suite in Las Vegas, a penchant for fast cars and loose women (or men) at work), it isn't possible to find a consistent profile of rogue traders. But that doesn't stop us from trying.

The problem with profiling is that there are so few rogue traders and the vast majority of traders don’t become rogues. As a result, we don’t have the statistical power to find any simple profile.

So what do we have to go on in finding and screening out rogue traders? Many factors are cited, but the sample size isn’t large enough to really prove any of these factors.

Here are a few of the common themes found (See the excellent source article):
1) Most have previously had some record of success.
2) They believe they are better than average traders.
3) They base their expectations on recent prior events.
4) They think they can make up the losses by taking more risk or working harder.
5) Isolation is common (living in a city outside their native country).

For the statistical example, suppose that Kerviel, Hunter (Brian Hunter of Amaranth Capital), and Iguchi (Toshihide Iguchi of Daiwa Bank) all owned toy poodles named “Fluffy.” Given that 1) they have accounted for a sizable proportion of all losses incurred by rogue traders, and 2) it is (fairly) rare for traders to own toy poodles named Fluffy, there is a strong correlation between toy poodle ownership and rogue trading. But as everyone knows, correlation does not equal causation.

MarketPsych Disclaimer: While we do not know the pet ownership habits of any rogue traders, I think it is safe to assume that pets do not cause rogue trading itself. However, we could be wrong. There are certain species of Koi that do, in fact, release neuroactive chemicals from their tear ducts which induce rapid and frenetic trading among genetically susceptible investors. The same may occur following exposure to toy poodle saliva. We simply can’t say.

A more interesting reason that it is so hard to profile rogue traders is the similarity of their trading styles to those of the greatest traders (huge losses notwithstanding). Many great traders have said that they made the bulk of their profits on a handful of trades or positions that went tremendously well.

For example, Warren Buffet is a famously low-turnover investor. What percentage of his current net worth can be attributed to his five best performing investments? Probably a lot.

Consider John Paulson, the trader with the single best trade in history [Trader Made Billions on Subprime] in which he made $3-4 billion for himself in 2007 by betting against subprime loans. In a telling recap of Paulson’s initial experiences betting against the bubble, the Wall Street Journal notes: “Housing remained strong, and the fund lost money. A concerned friend called asking Mr. Paulson if he was going to cut his losses. No, 'I’m adding’ to the bet, he responded, according to the investor. He told his wife, ‘It’s just a matter of waiting,’ and eased his stress with five-mile runs in Central Park.”

Peter Soros, a relative of George Soros, noted in the next paragraph: “Someone from more of a trading background would have blown the trade out and cut his losses.” But, “if anything, the losses made him more determined.”

Paulson made the largest return in history by sticking to his convictions, even when markets went against him.

It’s odd then, that “determination,” “adding to losing bets,” and “overconfidence” are also used to describe the follies of rogue traders. Rogue traders had concentrated positions that went against them…they added to the positions…and the markets went against them some more. Now they are in the history books (for unfortunate reasons).

In the excellent book, “When Genius Failed,” Roger Lowenstein notes that John Merriwether, founder of Long Term Capital Management, had successfully increased his investments in positions moving against him while at Solomon Brothers, even when management was terrified about the amount of risk the firm was taking. Of course, doubling down in losing positions eventually backfired on Merriwether, but only after he had launched the most lauded (and now vilified) hedge fund in history. And it should be noted that he is again a successful hedge fund manager.

So what is the lesson in this? Well, I would say:
1) Traders should be lauded not for the sizes of their gains, but the consistency and discipline of their returns.
However, the reality is that most people invest for returns, not consistency.

How about this lesson:
2) Don’t double-down on losses, cut them instead.

This is a trading classic. Yet there are many exceptions. Paulson didn’t cut losses, and he made the biggest trading profits in history. Buffett has said, “we prefer to hold our positions forever.” Buffett often can’t exit positions smoothly due to his size. Merriwether didn’t cut losses, and now he runs a successful hedge fund (granted, he did almost take down the global financial system, but that’s another story).

A quantitative risk-management system would be helpful in managing losses, but the markets are such that there are no optimal stop levels, except just below the entry price in some cases I’ve looked at.

Identifying rogue traders isn’t east, but perhaps the simplest technique is to identify those traders who have violated in-house risk management norms. There should be a no tolerance policy and immediate termination of employment. Without that kind of draconian enforcement, the rogues will never be caught, and will always be able to bend the rules just a little at a time, until the big one hits.

Buffett, Paulson, Soros, and (maybe) Merriwether have proven themselves as experts, and as such, they are working with investors who understand and trust that these guys can manage the risk dynamically. They don’t need hard-and-fast systems to enforce discipline.

But everyone else does...

Some additional reading:
“PROPHETS OF LOSS.” Andrew Cornell. 28/05/2004. Australian Financial Review. Page: 27
FEBRUARY 10, 1997 VOL. 149 NO. 6. INTERVIEW: "I DIDN'T SET OUT TO ROB A BANK". Time Magazine.
“Doubling The Risk Of Damnation.” Stephen Brown. January 21, 2004. Australian Financial Review.

Happy investing,

Thursday, February 07, 2008

How To Scare the Pants off an Investor

Fear may drive the markets. But when it comes to scaring investors, most people are amateurs.

Take all these doom and gloomers you see on TV. I bet they think they're reeeeeeally scary. With their "GDP numbers" and their "recession forecasts".

"Well, Sue, it's pretty bad out there. In fact, we've upped the likelihood of recession from 45% to 52% by Q2." (Pause for reaction).

Is that supposed to scare me? To you, I say, "Ha, would-be fearmonger! You've got nothing! I've seen Barbra Streisand movies that are scarier than that!"

(Actually, I find all Barbra Streisand movies utterly terrifying... perhaps that's a bad example)

You know why their analysis isn't scary? Because it's not emotion... it's math. I mean, you're not even engaging the right part of the human brain! (Dr. Peterson's opus is the definitive source on that subject).

"Uh, wait. There's a 52% chance of recession... but only a 76% chance of that. And that's only if LIBOR drops under 4%... Hold on, let me get my calculator." I mean, honestly.

Math is only scary when you're in 5th grade and are asked to go up to the blackboard and do long division problems in front of the class (and you know Mrs. Schecter picked you because she caught you passing notes to your buddy, Rob earlier in the day).

You want to know how to really scare the pants off investor? You want to really know how to get the stampede started?

First off, ditch the math. The odds of experiencing a loss don't scare people; it's the amount of that loss that scares people. This is the first crucial step toward sewing fear. Ever seen that show, Deal or No Deal? (e.g., I know my odds, but I could lose a guaranteed $300,000). It illustrates the difference beautifully.

And it's not just the degree of loss. Even that's still numbers, and number is the language of math. It's how those numbers will impact the quality of the investors' lives that generates the fear.

Investors have to imagine what they will feel like when the loss changes their lives. That's what turns their stomachs.

Also, fear is personal. You want to scare investors? You gotta make it personal.

You pictured sending your beloved son to an Ivy League School. You pictured walking across the quad and soaking in the beauty of the gorgeous Georgian style buildings and 300 year old Elm trees. How proud you would feel. Nothing but the best for your son! But...

There's no way you can afford that now. Your vision and his dream have been crushed. Instead, imagine the sense of shame and longing when you pull up to that shabby dorm at the state school with it's ugly utilitarian architecture. The best companies barely even recruit there. He'll never get the opportunities there you envisioned for him.

(MARKETPSYCH LEGAL COUNSEL DISCLAIMER): State schools provide excellent educational experiences. The quality of education is often superior to that of private colleges. In fact, Marketpsych founders have attended public schools, proudly. Moreover, many state schools have lovely campuses. They are not necessarily ugly or utilitarian, with the exception of the State University of New York at Buffalo's Amherst Campus which was apparently outsourced to the Soviet Ministry of Architecture in 1971.)

Not scary enough yet? Fine. You know that 0ctogenarian who was behind the counter at that chain book store? Remember the twinge of pathos you felt? Well guess what? You're going to be that guy because you can never afford to retire. Every morning you will put on your uniform, get the bus to the mall and spend all day on your aching feet squinting at book prices because your eye sight "isn't what it used to be". At lunch you will get a half an hour to eat the bologna sandwich you made that morning. You will be doing this the rest of your life.

I think we're getting warmer.

Lastly, add some regret. (i.e., And not only did this awful thing happen... but it was all your fault!)

Of course, different investors imagine different worst case scenarios. But we all have them. Wheyn you create the connection from how their investing loss would lead to that terrifying reality, and the investor actually pictures themselves in that situation and feels what it would feel like... that's when you really.

Fifty-two percent chance of a recession?

Whatever, math-guy.

Talk to me when we get to the catfood.