Risk takers and the tools to monitor them

Date: June 20, 2013

At a recent event hosted by the CFA Society of Toronto, I had the pleasure to listen to Dr. John Coates, a former trader who now is a neuroscience researcher at Cambridge University in the UK. 

His area of expertise is applying academic rigor in the area of physiology to determine how humans and in particular traders respond to risk. John’s research was really focused on high frequency traders or prop traders. He was able to determine that testosterone (yes, the hormone) levels had a quantifiable impact on a trader’s profit and loss each day. The theory was basically that high testosterone equates to profits and low testosterone means you get fired. This is interesting as we know that most trading floors are staffed by young men, who naturally have more testosterone coursing through their veins. So, yes, the stereotypical image of a young, aggressive and over confident trader who is making tons of money is realistic. The analogy here is to the famous Hollywood movie, Wall Street, staring Charlie Sheen and Michael Douglas (you know the Greed is Good tag line). For fans of this movie, we see that the young Charlie Sheen (with high levels of testosterone) outwits his mentor the older (lower levels of testosterone) Michael Douglas aka Gecko. Our astute researcher, John Coates could have easily predicted this outcome based on his research.

But, what is more interesting is that accompanying high levels of testosterone is also another hormone called cortisol. This is released by the body when under stress (i.e. when you need to prepare for flight or fight type of situations). Traders have very stressful jobs and so they typically have high levels of cortisol. We learn from Coates that regardless of a trader’s profits or losses that they still have lots cortisol in their blood. The unfortunate fact is that a person under constant stress becomes very unhealthy and thus why we see a lot of traders quit or retire after fairly short tenures.

Back to risk, I was also able to learn that when a trader is making a lot of profit, they become over confident and perhaps blind to the actual amount of risk that they are exposing their book and their employer too. This is why we see the big blow ups like the JP Morgan Whale trader and Jerome Kerval of Soc Gen lose billions of dollars. These guys (and the scandals are mostly caused by guys) just did not think that they could go wrong and that they had outsmarted Mr. Market. The flip side to this is that we see that traders who have more losing periods actually lose this confidence and become risk adverse. This means that until the trader gets back into a winning mode that they are actually not going to be too effective at their jobs.

Read: New Insights for Asset Managers: How Technology Can Drive the Most Effective Middle Offices

So, while this research is directed towards traders, I can’t help make the connection to portfolio managers (PM).  At StatPro, we don’t often deal with the trading teams directly but we spend a lot of time with the performance measurement, risk and portfolio management teams.  As the research has its origins in physiology and neuroscience, it is not a stretch to apply the same thinking to the asset management business.

A few concepts:

  • Monitor the PM for the number of winning periods; if we see too many winning periods does this mean that the PM and his team is getting too confident? Are they starting to stray into more risky asset classes? Are they dabbling in securities like options for the wrong reasons? For instance, applying an option collar around a big position to mitigate any downside is reasonable but putting on a naked short by entering in an options trade could be a sign that the overconfidence is causing the team to stray from their investment mandate. StatPro Revolution has a granual chart in our performance tab which shows this data in an easy to read scatter plot.
  • Attribution analysis: the ability to perform a bottom up attribution analysis can also indicate what types of activity is going on in the fund. A portfolio manager who is consistent in their investment strategy will show profits by making allocation and selection decisions that create positive returns. A tool like StatPro Revolution will allow the oversight team to see exactly how the PM is reacting over different time periods. The tool could point out any disturbing trends that are emerging, like for instance, consistently over allocating to favorite but poorly performing stocks (perhaps the PM is piling into a bad trade in the hopes of a recovery). The other scenario is that the PM is consistently missing out on taking positions that are really performing well for the benchmark but are held in the fund.
  • VaR: The beauty of a tool like StatPro Revolution is that it provides ex-ante (forward looking) risk.  This is no small feat and StatPro runs a massive historical simulation each day to come up with security level VaR for a huge number of securities. A quick look at one of the VaR heat maps will also show if the PM is overweight on risky stocks. This heat map has proven to be very popular since it takes an extremely complex analysis and presents it in a simple to understand chart.

If you are finding this link between risk and how financial services professionals react to stress, I suggest reading John Coates book.  It is called “The hour between Wolf and Dog – Risk Taking, Gut Feelings, and the Biology of Boom and Bust.”

Finally, the financial services industry is really all about risk management and having access to information. I found it refreshing to learn about the application of neuroscience and physiology to the topic of financial risk management. It makes sense and I do hope that firms start to apply this logic to their management skill set.

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