Monday, December 19, 2011

Volume 3 Issue 51: Intelligent Investing

The Making Of A Rogue Trader

Who would have thought that doubling down and going for broke in times of desperation is an instinctive response that are found in the yellow-eyed junco (a type of bird)?:
"To know what goes on in the mind of a rogue trader – and that of every reckless gambler – it helps to be a bird-watcher. The yellow-eyed junco is a type of sparrow found in Mexico and the southern USA. Thirty years ago, three evolutionary biologists at the University of Arizona carried out a series of experiments with seven yellow-eyed juncos that had been caught in the south-east of the state. 
"The experiments were designed to test the birds’ gambling instincts, and the results were intriguing. One bird at a time was placed on a perch in an aviary 3.5 metres from two dishes covered with paper so that it could not spy the contents. The bird was trained to realize that if it flew to the first dish, it would always find two millet seeds to eat; if it flew to the second, it couldn’t be sure of what it would contain. Half the time, there would be four seeds, and half the time there would be none. The biologists were trying to discover how much risk the juncos would take in foraging for food – their main activity in the wild. Mathematically, the two choices were identical since a 100 per cent chance of two seeds was the same as a 50 per cent chance of four…. 
"In the first experiment, the birds were kept hungry for an hour and then allowed to start choosing dishes, with the seeds being replenished every thirty seconds. This meant that, whichever one they chose, they would get plenty to eat unless they were very unlucky. The juncos responded by being risk averse: in nineteen out of twenty-five cases, they chose the sure thing – the dish with two seeds – rather than risk finding nothing. 
"Next, the birds were starved for four hours, and the seeds were replenished only every minute. That tipped the birds into what the scientists called ‘a negative net energy budget’ – gaining two seeds each time they made a choice would not provide enough food to satisfy their hunger, and ultimately to keep them alive and enable them to reproduce. The birds responded by flying to the other dish instead. Facing loss, they started to gamble. 
"The scientists, led by Thomas Caraco, now a biology professor at the State University of New York, concluded that ‘juncos in nature will generally avoid risk unless they face difficult energetic stress’. In other words, they will choose the safe option for feeding – the closest natural equivalent to financial traders making money – unless they find themselves in danger, either through hunger or because it is chilly and they face a cold night requiring reserves of energy. 
"The choices are instinctive rather than intellectual, and they make evolutionary sense for the species. ‘Facing the possibility of starvation, animals are willing to gamble on the “strike-it-rich” policy of risk-prone foraging,’ writes Barry Sinervo, a professor of ecology at the University of California. ‘Some foragers will have a string of bad luck and starve. Some will have a string of average luck and still starve. However, there will always be those lucky few that experience a string of good luck. It is those lucky few that survive and pass on genes to the next generation’…" 
--John Gapper, How to Be a Rogue Trader
Maybe that is why some people say that traders have to have good instincts. As for me, I think that is why trading is most definitely not for everyone and is highly risky for the uninitiated. It relies heavily on instincts and emotions. Of course, you can throw in charting and technical analysis to help "remove" the emotional element, but very often, we see what we want to see.

HT: Brad DeLong