"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.