Dec 4, 2011- Rogue Traders are Exhibiting Darwinian Instincts

Financial Times’ John Gapper has written an excellent article recently.  I recommend any trader/investor to read it.

What makes a rogue trader? by John Gapper

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My Personal Summary of Observations/Favorite lines in the article:

It’s interesting to know in the article, that rogue traders who double up or average down (Martingale’s system) or what we call gambling when the chips are already down, is a trait that’s not simply shared in humans, but across birds and other animals.  In a study made by biologists at University of Arizona, yellow-eyed junco birds who were starved for 4 hours, faced with losses started to gamble.  Normally, these juncos will generally avoid risk unless they face difficult energetic stress.

John Gapper writes:
In other words, they will choose the safe option for feeding – the closest natural equivalent to financial traders making money – unless they are in danger, either through hunger or cold. They will then switch from “risk aversion” to “loss aversion” – gambling in search of a bigger pay-off.

This phenomenon is not confined to sparrows. Experiments have found similar behaviour in mammals such as shrews and insects such as bumblebees. The difference is that bumblebees’ responses are triggered by collective stress – in one test, they preferred blue flowers with a constant amount of nectar to yellow flowers with a variable amount as long as the colony had plenty of honey in store. As soon as it ran short, its members chose the yellow flowers.

The Famous Kahneman Tversky Experiments

In experiments at universities in Tel Aviv, Stockholm and Michigan, Kahneman and Tversky set groups of people a series of tests. In one, they asked them whether, given a choice of gaining 450 units of the local currency, they would settle for that or take a 50-50 gamble on winning 1,000. Mathematically, the average gain was 500 – more than the 450 – yet the subjects were overwhelmingly risk averse. They chose the safe gain rather than the risky bet.

The psychologists then reversed the experiment (and a series of related ones) by offering the subjects a choice either of settling for a definite loss of 450, or taking a 50-50 gamble on losing 1,000 or losing nothing. This time, they rejected the definite loss for a half-chance of escaping unscathed.

Like other animals, they started to gamble.

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– This article made me realize very important phrases I was told before-
1.) Scared Money Never Wins.
2.) You have to unlearn everything that’s human about you.  It’s normal human nature (Darwinian) to average down.  But the right thing to do is to average up.  It’s normal human nature to avoid losses, but the right thing to do in the market, is to cut the loss when one sees it.  It’s normal for humans to take profits when one sees it, but it’s right to hold onto it for the longest possible time, as long as one is ahead.
Rogue traders were too risk averse, too scared to lose money, ending up losing more money than they can handle.
The desperate scramble to avoid losses at all costs is a defining characteristic of the rogue trader.
The rogue trader may appear to be acting strangely, but he does what comes naturally. – John Gapper
MOST BREAKING INSIGHT
“Faced with life-threatening circumstances,” they say, “even the most disciplined individual may not be able to engage in individually rational behaviour thanks to adaptive ‘hard-wired’ neural mechanisms that conferred survival benefits to the species.” The survival of the fittest, they add, underlies “modern adaptations such as boredom, thrill-seeking behaviour, rebellion, innovation, and most recently, financial market bubbles and crashes… From an evolutionary perspective, financial markets are neither efficient nor irrational – they are merely adaptive.”
Watch this video.  🙂  Courtesy of Reformed Broker good-morning-i-am-the-rogue-trader
– Faceless Trader ( I want to read this book Fake: My Life as a Rogue Trader by Mr. David Bullen)
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One Response to Dec 4, 2011- Rogue Traders are Exhibiting Darwinian Instincts

  1. Great article. Thanks for sharing.
    I still average down but I’ve learned to average up as well. What I want to learn next is how to prolong my gains.

    Tried selling only a portion of my position when the stock went up. This worked for LC because it went further up but didn’t work so well with MA since it went down after touching .067.

    Like

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