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"Are investors and traders naturally irrational with money and risk?" That's the opening line of my new article in the July issue of SFO magazine titled "The Mental Models of Financial Self-Sabotage." I started asking this question about five years ago after feeling reasonably confident that I had learned how to trade by paying attention to the mental game, but noticing that many traders around me still seemed to ignore the psychological aspects of managing risk and reward in markets. With four years of institutional foreign exchange experience behind me, I began studying why it was so difficult for most traders, including myself, to internalize the discipline required to create long-term success in the markets. One of the most fruitful areas of research was the wealth of trading failure I saw all around me, whether on the trading floor, the interbank desk, or the occasional blow up - or rogue trader - at a bank or hedge fund. Thus, I voraciously observed traders and trading behavior at all levels, looking for what the failures, as well as the success stories, had in common.
While shareholders and regulators will continually struggle with the "how" of financial failure and fraud (as in "How did this happen? We're simply stunned!"), we are still faced with the much older - and more interesting - question of "why." Why do smart traders, money managers, and those in high places ultimately responsible for firm-wide risk seem to so frequently be involved in behaviors that take down their own ship? Professional investors and traders offer a fascinating window on irresponsible financial behavior because the objects and supposed goals of their actions are the same as ours - grow our investment assets over time while balancing returns we desire with risks we can tolerate. Extreme examples of irrational self-sabotage among the pros can provide clues about where it all goes wrong when the smart get greedy, reckless, or just plain stupid.
A closer look at the pros finds that the "rogues' gallery" of lone gunmen, like Nick Leeson, of the 1995 Barings Bank collapse, John Rusnak, who hid losses of nearly $700 million between 1997 and 2002 while a currency trader for Allied Irish Bank, and this year's poster boy Jerome Kerviel, who lost $7+ billion for investment bank Societe Generale, is not so far removed-or beneath-the "mensa club" of hedge fund masters who have caused as much, if not more, damage. LTCM was well-profiled in Roger Lowenstein's When Genius Failed as having the smartest minds extreme amounts of leverage could buy, while Amaranth's natural gas trading super-star Brian Hunter was not a solo risk-taker in his multi-strategy, model-based firm's collapse.
I wanted to figure out what drove these debacles because I knew that the only difference between them and the independent investor-trader who just blew up his small five-figure account was the amount of money lost. The psychology and the decision making was the same, no matter how masked in supposed expertise, skill, or well-devised strategies. I eagerly studied the stories of trader blow-ups, whether starring reckless money managers like Victor Neiderhoffer, the pit traders who left the floor every month in defeat, or the occasional rogue whose daredevil stunt destroyed a centuries-old institution. And this study led to an interest in how traders and investors managed risk, whether in the trading pit or behind the secretive walls of a hedge fund or investment bank proprietary "war room." The one theme that stood out among all these stories was how ignorant most sophisticated financial pros were of their own psychological makeup and how their emotions drove their decision making-no matter how much they convinced themselves that they were rational and in control.
The Market Wizards books by Jack Schwager offered plenty of wisdom about risk by smart traders who had survived their own spectacular losses and lived to tell, and trade again. If traders couldn't learn something from the dozens of pros in those stories who faced the abyss and returned with new rules and better habits concerning discipline, systems, psychology, and of course, risk, then they definitely weren't paying attention. And all these lessons were available in the early 1990's, fueled as much by the older stories of Jesse Livermore or Bernard Baruch.
Why didn't traders learn from those who went before them, and whom they purported to emulate, at least financially? I speculated that rogue traders and out-of-control fund managers made their blunders (or performed their misdeeds) because of several psychological flaws that had a little less to do with greed and the corruption of power and a little more to do with ego and logic issues that clouded their judgment and betrayed a lack of solid grounding in financial rigor or responsibility. Yes, institutional traders are often tempted by performance-based bonuses to make good numbers at any cost. But, when things go badly and losses continue to accumulate, there is usually something else driving the debacle. Here are three "fatal flaws of finance" that I thought seemed to keep cropping up in the stories of financial meltdowns:
The net results of my informal research were two pillars of understanding for traders and investors-one about human emotion and one about logic. The emotional one I fully expected, knowing that we are masters of self-sabotage and can talk ourselves out of a small winning position and into a bigger losing one faster than you can say "cut your losses and let your winners run." Whether fear or arrogance overrides reason, the results were usually the same. And the operating beliefs which psychologists would say rule our behavior are usually so unconscious as to be hidden under a labyrinth of complex rationalizations, so that actions are easily driven by emotion in the heat of battle and later explained away with excuses.
The logical pillar, on the other hand, was something I only half expected-and didn't want to be true because it involved math, and to say that I was not the best math student growing up would be putting it kindly. I thought for the first half of my trading career that I could get away with "understanding the concepts" of probability and expectation, without really being able to do the equations. But the more I studied hedge fund returns and risk metrics, the more I saw that the smartest traders relied on statistical analysis of their systems, methods, and results. Traders and investors who weren't willing to do that work, even on the simplest level of measuring risk/reward ratios and equity swings, were usually the ones destined to blow up. The ones that did pay attention to some kind of risk metrics, both historical and real-time, were more likely to survive.
As I slowly taught myself probability and statistics as insurance against my own erratic, irrational, emotional decision making, I became aware of two fields of science that seemed to support my findings. Incredible advances in neuroscience, via sophisticated brain imaging technology, were simultaneously debunking and verifying decades of psychological theory about our emotional thought processes and behavior. And behavioral finance had been studying how people make decisions under uncertainty and risk for over thirty years-and how incredibly ignorant of probability most people were when they made those decisions. With this abundance of scientific research to support what I saw among traders, I thought I had stumbled upon some sort of missing link in trader education and training. Training "turtles" to have the discipline to follow long-term trends was not the same as teaching people how to day trade. I took as my model, in particular, how smart options traders approached the markets each day with systematic discipline and risk control. Their "edge" was always quantified, never emotional-or at least not overly influenced by emotion in any way that could disrupt the positive mathematical expectation of their system.
In 2005, I combined my first-hand, practical trader knowledge (from six years of high-volume, high-frequency interbank experience) with this new (at least to me) probability and scientific knowledge to write a thesis I called "Your Brain Wasn't Made to Trade." My central theme was that our brains evolved for much different challenges than calm analysis, probability-focused decision making, delayed gratification, discipline, and long-term investing patience. And I used evidence from both neuroscience and behavioral finance to explain my theory. In this unpublished 8,000 word working paper, I didn't say that long-term success was impossible for investors and traders. I just detailed why the odds were against us and that without structured training and planning, and a quantifiable system with positive expected return, then no amount of money could make us successful. It doesn't mean we are all walking time bombs, seconds away from breaking into crime sprees or other reckless behavior. It just means irrationality is an unconscious and powerful part of all of us, so it comes easy and discipline does not. We have to work hard, and smart, at becoming more disciplined and overcoming our natural irrationality.
Behavioral finance is the common name given to the fusion of psychology and economics, with researchers from both fields working on different aspects of human decision making under uncertainty and risk. Since the 1960's, experimental evidence has been building that proves how typically irrational people can be when faced with everyday challenges and other financial or ethical dilemmas. And cognitive neuroscience reveals why we are irrational and shows us clear strategies and tactics for working with our brains to develop more discipline and get the results we want from our market campaigns. As a conclusion to the "Your Brain Wasn't Made to Trade" thesis, I also introduced a three-step solution to building discipline from the ground up and the top down. Called "The System Underneath Your System," it offered excellent ways to construct your trading plans and systems with probability, risk control, and optimal profit at the core.
My SFO article, "The Mental Models of Financial Self-Sabotage," takes only half of the argument on, that of the behavioral finance scientists, whether psychologist or economist. To learn more about that research, be sure to pick up a copy of the July edition of SFO magazine. You can get a free subscription online at www.sfomag.com. When the magazine publishes the July issue in late June, the SFO website will also be hosting two additional resources as supplements to the article. One is a "Rogues' Gallery of Risk and Ruin" highlighting the lone gunmen that have caused large trading losses, and the other is a list of Recommended Reading in behavioral finance and "neuroeconomics." Enjoy!
