January 2, 2014

When Good Traders Go Bad

Today's bad decisions can become tomorrow's legal disasters. Here's how to recognize the pattern of a trader about to go rogue.

By

Matt Samelson

Media coverage would have us believe that detrimental activity in the capital markets-including criminal behavior-is limited to individuals who are "different" from us. Many of us, as onlookers, believe that illicit, unethical or illegal acts are beyond us, that we would absolutely behave differently were we in the shoes of those we hear and read about.

Matt Samelson

Thanks to the concept of risk and return decision-making, we are not as quick to accept that conclusion.

Critics are quick to vilify (as they should) individuals and managements engaged in questionable and illegal market activities. Bernie Madoff, SAC, JPMorgan Chase's London Whale and the Libor scandal provide ready examples. The fascinating thing about these "over-the-top" activities is that they are almost always grounded in the same fundamental decision-making practices Wall Street professionals use every day-at least at the outset.

Professionals make decisions every day. Some yield favorable results, while others turn out unfavorably. Unfavorable results are acceptable and expected. These routine decisions, individually, usually do not have a material impact on ongoing business. Some decisions may be questionable or inappropriate, but as the cautionary tales above illustrate, the payoffs can be greater than for routine decisions. Therein lies the temptation. No trader sets out to fail, let alone be fitted for handcuffs.

RISK AND RETURN IN DECISION-MAKING

The concepts of risk and return are familiar to everyone in capital markets. While they have obvious and direct implications in investment management and trading, so called "risk-based decision-making" can be a formal, defined, conceptual process, or one that is hardly noticed. In most cases, it depends on the perceived magnitude of the matter at hand.

In its most basic form, risk-based decision-making involves two factors: potential gravity (acuteness of the decision) and outcome probability (probability associated with favorable or unfavorable outcomes).

There is a wealth of academic research on these matters, and behavioral finance and economics are becoming increasingly important. However, it is clear that risk-weighting decisions in a logical and methodical manner will help clarify the impacts of a range of potential outcomes. And that knowledge helps a decision maker take optimal action.

DECISIONS IN A PRESSURE COOKER

Most industry professionals do not set out to defraud clients or create systemic events that will destroy their company. On the contrary, they spend years, if not decades, establishing reputations, demonstrating their abilities and building successful careers. The leap from bad decision-making to recklessness and illegality can occur subtly. It could start as simply as a bad split-second calculation made under stress. A trader may pursue an excessively risky proprietary trading position outside normal limits in an organization with a weak control structure. A successful trader may make the mistake of overestimating his or her capabilities or underestimating the market forces arrayed on the other side. A portfolio manager might impulsively act on nonpublic material information.