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Thursday, February 7, 2008

Craving the High That Risky Trading Can Bring

February 7, 2008

Craving the High That Risky Trading Can Bring


It is easy to dismiss Jérôme Kerviel, the rogue trader at Société Générale
_generale/index.html?inline=nyt-org> , 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
d_university/index.html?inline=nyt-org> 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 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
usetts_institute_of_technology/index.html?inline=nyt-org> 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
nline=nyt-classifier> -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
university/index.html?inline=nyt-org> 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
tt/index.html?inline=nyt-per> 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

Legendary Wall Street traders like Steven A. Cohen and Julian H. Robertson
tson_jr/index.html?inline=nyt-per> 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.

Copyright 2008 The New York Times Company

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