LONDON/NEW YORK (Reuters) - How often have you sat on losses, in the hope that fortune will shine and turn your shortfalls into gains?
It is a trait in all of us, say those who study trading.
As the probe into what led to a $7 billion loss by a junior employee on the equities derivatives desk at French bank Societe Generale intensifies, everyone wants to know how a trader could allow such losses to spiral.
“It is human nature not to take a loss and that is simply because once you take a loss you kind of admit that it’s failed, it’s a disaster, it’s over,” said Jack Schwager, who interviewed traders around the world for his “Market Wizards” books.
Schwager said investors who found themselves trading through black holes often felt convinced they could find a way to get back into profit, no matter how long the odds were.
“As long as you are not (booking) a loss you can kind of convince yourself there is still hope,” said Schwager, who is also a portfolio manager with UK-based funds group Fortune.
“It doesn’t really make a difference if it is ten million, a hundred million, one billion or seven billion because once it gets really bad it is the same outcome for the trader,” he said.
The stocks derivatives scam which has led to 31-year-old Jerome Kerviel’s face on newspapers across Europe has reminded anyone with an interest in the integrity of markets that no matter how many checks, there is no escaping human frailty.
“It’s something any trader could go through — racking up some initial losses and instead of taking the loss and just moving on, you end up adding to losing positions,” said Brett Steenbarger, a clinical psychologist who wrote “The Psychology of Trading.”
“But he (Kerviel) may have been in a real bind because he didn’t have the ability to openly take the loss and acknowledge what he did. He was trapped.”
This feeling of being trapped can cause panic and trigger what psychologists call a “fight or flight” stress response.
“But then you have a panic situation where the bottom falls out of those positions. The motivations he started out with may have been different than the motivations that blew him up,” Steenbarger added.
The bias of investors and traders to cut profits early but go on running losses, no matter how big, is well documented.
In 2002, Daniel Kahneman won the Nobel economics prize on the back of experiments he designed explaining why people can make irrational economic choices in a theoretically “rational” market. His work noted how people are highly averse to losses.
“You simply feel when you have made a loss that it isn’t really your fault and it will come good in the end,” said Gordon Gemmill, professor of finance at the Warwick Business School in Coventry, central England.
“You haven’t got anything to lose anymore - you’re already in the mire and you are not going to get out so you go for higher and higher stakes. That is typically what happens, everybody has over confidence in their own ability,” he said.
The trader at the heart of the alleged SocGen fraud — the biggest trading scandal in history — is alleged to have circumvented the bank’s risk controls through in-depth knowledge of its systems, but was caught when he tried to cover up losses.
“I think this is more of a case study for people who design back office controls as opposed to people concerned about the psychology of trading,” said Schwager. “This is just an extreme case of being unable to get out of a losing trade.”
As for how the junior trader feels now that fraud scandal is out in the open, Nick Leeson, who brought down Britain’s Barings in the 1990s, said it would be a mixture of emotions.
“I am sure he is very scared. I would imagine as well that yesterday morning there would have been a perverse sense of relief because he has not been able to bring it to an end himself,” Leeson told Irish public broadcaster RTE on Friday.
Leeson, who racked up losses through illegal trades in Singapore, said “you distance yourself somehow from the quantity of it”.
“It tends to be numbers that come up on the screen — it does not have the real factor such as the money you have in your pocket,” he said.
(Editing by Alexander Smith)
Reporting by Gavin Haycock in London and Emily Chasan in New York; additional reporting by Jonathan Saul in Dublin