Friends of friends recently went to a casino. They had a plan. They would place a bet, and if they lost, they would double the size of the next bet, hoping to make it back. And if they lost again, they would double the size of the bet once more, and if they lost again, they would double the size of the bet once again. You have to win eventually!
Actually, there is no rule that says you have to win eventually. The fair coin can come up tails a hundred times in a row. Needless to say, that casino trip came to a very unhappy end.
The technical name for this is a 'martingale.' The reason that a martingale betting strategy is attractive is because people forget that most occurrences in life are independent; it doesn't matter that you flipped tails 100 times in a row, the probability that it comes up heads is still fifty percent. And it doesn't matter that you shorted Swiss Franc 20 times in a row, the probability that it actually goes down is still fifty percent.
I was an ETF trader at Lehman Brothers, so I had the same job as Kweku Adoboli, the UBS trader arrested recently for concealing $2 billion in losses. I was also an index arbitrage trader, the same job as Jerome Kerviel, SocGen's swashbuckler who lost multiple billions a few years ago.
And I gotta tell you: it is hard to go rogue in the electronic age. Just about every futures contract or share of stock is electronic - your positions feed directly into risk management systems - so the only way to get around the safety measures is to have an intimate knowledge of how the systems work, as both these guys did. It's not like the old days of hiding trade tickets in the bottom drawer.
I was never tempted to go rogue, not even when I was down $4.6 million in one day. Most people don't even feel the urge, and if they do, they resist it. So it's easy for us to say that Adoboli is a bad guy, and for lying, he is, in a very banal way. However, this is more a matter of psychology.
One of the first rules you learn on Wall Street is that you never add to a losing position. Things can quickly spiral out of control, and everybody knows it. But there will always be people who feel that 1) they are bigger than the market, and 2) mean reversion will take hold eventually.
They aren't, and it won't.
We have a tendency to think that we are due after we strike out a lot, or miss a lot of basketball shots, or get turned down by a lot of girls. But there are very few things in life that happen that are dependent on what happened before. Unfortunately, the psychology behind being due is very powerful.
While it may seem like rogue trading incidents happen all the time, and they sort of do, it's important to note that nearly all traders are professional and disciplined about risk. One of the hardest things to do while learning how to trade is to take a loss, because it flies in the face of another powerful psychological urge to hope that a trade will come back.
Hope is not a strategy.
But there is a tiny percentage of traders (and an equal if not larger percentage in the general population) who have something in their chromosomes that makes them so stubborn, so arrogant, so boneheaded that they cannot admit that they are wrong, and they'll go down with the ship in a losing position, taking out an entire investment bank in the process. The problem is, there is no way to screen these guys; not even the most sophisticated personality tests will tell you who they are.
Traders, believe it or not, are some of the most humble people you will ever meet (at least beneath the surface) because they are forced to admit defeat several dozen times on a daily basis. But as children, we are taught to never quit. Never give up. No son of mine is going to be a quitter.
As it turns out, quitting is a fantastic idea. I can think of at least one military conflict where we should have quit, instead of pursuing a losing martingale betting strategy. I can think of literally dozens of economic policies that we should have quit, instead of pursuing a losing martingale betting strategy. Quitting is good. Quitting is smart. Quitting lets you live another day.
But who can be blamed for wanting to win?
Jared Dillian's book, Street Freak: Money and Madness at Lehman Brothers, was published last week by Touchstone.