Thursday, February 07, 2008

Craving the High That Risky Trading Can Bring


The article was so good that I wanted to reproduce this in its entirety rather than make a synopsis of this. The article featured in the New York Times on February 7, 2008.

BY JENNY ANDERSON

It is easy to dismiss Jérôme Kerviel, the rogue trader at Société Générale, as a fluke.

So here is a sobering thought for Wall Street: There may be a bit of Mr. Kerviel in all of us.

A small group of scientists, including some psychologists, say they are starting to discover what many Wall Street professionals have long suspected — that people are hard-wired for money. The human brain, these researchers say, responds to high-stakes trading just as it does to the lure of sex. And the riskier the trades get, the more the brain craves them.

French prosecutors have likened Mr. Kerviel’s trades to a drug habit. That is no surprise to Brian Knutson, a professor of psychology and neuroscience at Stanford University and a pioneer in neurofinance, an emerging field that combines psychology, neuroscience and economics, to examine how the brain makes decisions.

Mr. Knutson has sent volunteers through high-power imaging machines to map their brains as they trade. He concludes that sometimes, people get high on making money.

“The more you think you can gain from the risk, the more you take the risk and the more activation in the circuitry,” Mr. Knutson said.

Neuroeconomics has not won many converts on Wall Street. Researchers like Mr. Knutson have yet to show how their work can be applied effectively in the markets. And some academics question whether the field is of any use in economics.

“Economics is about equilibrium, and supply and demand, and forces that come to some stabilized system,” says Stephen A. Ross, the Franco Modigliani Professor of Finance and Economics at the Massachusetts Institute of Technology. “It’s not about atoms or how little people behave.”

Even so, the field seems to be gaining some traction. Last year Jason Zweig, who edited the 2003 edition of “The Intelligent Investor” by Benjamin Graham, wrote a 352-page book entitled “Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make Your Rich.”

One of his findings was that brain images of drug addicts who are about to take another hit are indistinguishable from those of traders who are making money and about to place another trade. “That tells us pretty confidently that if you make money and make money again,” Mr. Zweig said, “it is very similar to a chemical addiction and it becomes very hard to let go.”

Mr. Kerviel, 31, told prosecutors that he was thrilled when his surreptitious trades in European stock index futures began to pay off. By late December, he had made a profit of about $2 billion. “That produced a desire to continue,” Mr. Kerviel said. “There was a snowball effect.”

But when the markets turned against him, Mr. Kerviel made an all-too-common mistake: He refused to cut his losses, which would balloon to more than $7 billion as the bank frantically unwound his positions on Jan. 21-22.

Daniel Kahneman, a Nobel Prize-winning psychologist, showed that individuals do not always act rationally when faced with uncertainty in decision making. When faced with losses, individuals may seek to take more risk rather than less, contrary to what traditional economic thought might suggest.

“When you are threatened with extinction, you act like nothing matters,” said Andrew Lo, a professor at M.I.T. who has studied the role of emotions in trading. Mr. Kerviel, he said, is a case study in loss aversion.

Mr. Lo and Dmitry V. Repin of Boston University have studied traders to determine how stress and emotions affect investment returns. They monitored traders’ vital signs like heart rate, body temperature and respiration as their subjects darted in and out of trades.

The findings, while preliminary, suggest — perhaps unsurprisingly — that traders who let their emotions get the best of them tend to fare poorly in the markets. But traders who rely on logic alone don’t do that well either. The most successful ones use their emotions to their advantage without letting the feelings overwhelm them.

“The best traders are the ones who have controlled emotional responses,” Mr. Lo said. “Professional athletes have the same reaction — they use emotion to psych them up, but they don’t let those emotions take them over.”

Or, as Warren E. Buffett once put it, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”

Of course most traders do not breach ethical boundaries like Mr. Kerviel, who doctored e-mail messages to hide his unauthorized trades. But unbridled ambition and the hit from the money high are a dangerous combination.

People like to think that logic prevails in the financial markets, that traders and investors always act rationally. “Clearly, institutional investors want to believe it’s all scientific,” said Mark W. Yusko, president of Morgan Creek Capital Management.

But Wall Street can get carried away. The Internet boom and bust were followed by an even bigger boom and bust in mortgage lending. Wall Street is now saddled with more than $100 billion in losses stemming from mortgage investments, and the economy may be sliding into recession.

Alpesh Patel, principal at the Praefinium Group, an asset management company, said that when traders get too emotional, they start making bigger, more frequent trades.

“You know you are damaging yourself, and there’s no gain in a financial sense, but the highs from the winning lead you to take bigger risks,” said Mr. Patel, who has written 11 books on trading psychology and risk management.

Legendary Wall Street traders like Steven A. Cohen and Julian H. Robertson Jr. are students of human emotion. Mr. Cohen, who runs a $15 billion hedge fund called SAC Capital Advisors, keeps Ari Kiev, a psychiatrist, on hand to work with his legions of traders, people from SAC say. (Dr. Kiev declined to say whether he worked for Mr. Cohen’s firm.)

Mr. Robertson, the founder of Tiger Management, which at its peak in 1998 managed $22 billion, turned to a psychoanalyst, Dr. Aaron Stern, to test and evaluate Tiger’s traders.

Dr. Kiev, author of the forthcoming “Mastering Trading Stress: Strategies for Maximizing Performance,” said many traders, professionals and everyday investors alike, fail to manage their risks.

“It is more common for people to hold onto losers and see their investment go to zero, or shorts go to the sky, than it is for them to practice good risk management and get out,” Dr. Kiev said.

1 Comment:

naresh nambisan said...

nice intresting stuff.....its true,..money brings the kick....is there a provision for me to get alerts as and when u post something on ur blog??

KM

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