Thami Kabbaj : « Behavioral finance has shown the presence of psychological biases among traders »

According to Thami Kabbaj, some traders are in a state of cognitive dissonance: They totally obscure the loss and focus solely on the information that reinforces.

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Thami Kabbaj, former proprietary trader, currently associate professor of economics and founder of, a trading training center, has just published the second edition of the book "Psychologie des grands traders" (Inside the mind of world leading traders) enriched by the lessons of the financial crisis. It analyzes for us the process that can bring an experienced trader to hide his losses ...

What does the fraud of Trader Kweku Adoboli inspire just three years after the Kerviel affair?

At first I was surprised even though this case has not been felt with the same intensity as the Kerviel affair. We have lived so many tragic moments since January 2008 that the case goes almost unnoticed...nevertheless, it clearly breaks out at the wrong time with the major world powers seeking to reassure the public about the solvency of banks and financial system. This latest scandal comes to support the arguments of those who recuse the financial markets

What is the process that can bring an experienced trader to hide losses and make up positions ? Fear of losing ? The infernal pressure in trading floors ?

Each path is unique. However, with hindsight, we can only note the striking similarities between the different cases...Generally, the term "rogue trader" is only mentioned during extreme events such as the Nick Leeson affair in Barings or that of Jerome Kerviel for the SG. This loss of rationality is often seen as an extreme pathological case, even if others will discuss a defaulting ethic of the trader.

However, several research in behavioral finance have shown the crucial role of emotions in trading. Behavioral finance has shown the presence of psychological biases among traders, which are a departure from the state of perfect rationality and can be classified into two broad categories:
-cognitive biases highlight the influence of our knowledge and beliefs in decision-making. they correspond to erroneous principles acquired by an individual during childhood or education and on which it will rely in making its decisions.
-emotional biases highlight the negative effects of emotions on our performance.

Researchers Kahneman and Tversky have shown in their theory of random perspective, the unfortunate tendency for traders to take profits quickly and avoid cutting their losses. This result is explained by the fact that the rewards of an additional gain is well below the pain felt by the trader for a loss of the same order[1]. thus, the trader will often refuse to lose, because the realization of the loss symbolizes his failure, he refuses because he is victim of his ego. the trader is in a state of cognitive dissonance: it totally obscures the loss and focuses solely on the information that reinforces. For example, if the market draws an adverse movement in relation to the trader scenario, the trader will minimize this information and consider the market behavior as temporary. he seeks to avoid emotional pain and starts hoping.

The competition is often fierce in a trading floor and the race for bonus is real. For all to see, a good trader is primarily the one whose bonus is the highest. this environment can induce a minority of traders to take huge risks and sometimes breaking the rules, only with a view to shine against the others... This view is reinforced by the following observation: even in the case of fraud, the mobile is rarely about personal gain. In fact, it is difficult or impossible for a trader to divert the bank’s money to his own advantage. the mainspring of Nick Leeson or Jerome Kerviel was never personal enrichment but a "burning desire to shine". Nick Leeson was regarded by his superiors as a star trader and was revered by his peers. The desire to preserve the reputation has certainly encouraged to use his knowledge of operations control to cover his losses and give the illusion of a real market expertise. The situation of Jerome Kerviel strangely resembles that of former British colleague. Coming from a humble background, he had a strong desire to prove he was an exceptional trader. Kweku Adoboli meanwhile, did not come from humble background. yet this desire to shine has probably pushed him to commit the irreparable.

The world of finance (Banks, asset management firms, universities & Masters in finance) fail in general psychology. Yet in recent years, you are advocating a greater consideration of this matter in the teaching of professional trading. Have you been heard ? the banks, have they followed your advice ?

The most adavnced courses in financial markets focus on financial mathematics at the expense of other sciences called "soft" like psychology . this training enhances the feeling of an omniscient and rational trader. But a sound scientific education is not enough to operate at the highest level in the markets. In France there is a strong school of mathematics which has a deciseive influence on the content of university education but also continuing education. some scholars, including Helyett Geman, explain that the psychological dimension is not taught in trading training because the banks have to train their employees in this discipline. This reasoning is wrong because the initial university education strongly influences the continuing education programs implemented in these financial institutions. In addition, this training is often provided by academics, yet the academic industry should play a more active role by highlighting the recent developments in financial theory.

Upon the outbreak of the Kerviel affair, I repeated on many TV shows and in numerous newspaper articles, the crucial importance of the psychological dimension in financial markets.

In fact, I taught this subject in some universities, including Paris-dauphine and Paris II Assas. I also lectured extensively on this subject and gave some seminars in financial institutions

I felt some satisfaction in the bill referring to spread the bonus over time. Indeed, the trader should not get his full bonus at the end of the year but a portion will be paid after a delay period. this measure makes it possible to encourage traders to focus on the long-term process, and avoid short-term pitfalls. yet we can only note that this is insufficient and we will have to seriously take into account this dimension. Unfortunately Market participants have a short memory, but that’s what makes the specificity of this business

Trading is an activity requiring a lot of involvement, therefore few people can really take some distance to focus on the factors that ensure success in this field but also manage the risk optimally.

A few weeks ago UBS believed to be one of the safest banks in risk management. Despite the resources invested we see that this is clearly not the case. However, in defense of banks, the fraud, is it not itself inherent in any risky business ? Should we punish banks "abused" by their traders ?

The major financial institutions have implemented very strict control procedures to monitor their traders exposure and to prevent any wrongdoing. Apparently, these measures were not effective enough.
It is hard to overwhelm a bank that has just suffered a large loss due to a malicious trader. However, any bank is somehow responsible. Again, anyone can create damages in financial markets. Beyond the ethical dimension, the markets can confuse rationality and encourage individual to commit thoughtless acts. there is obviously a limit not to be crossed, that is the capital allocated to operate. However, when the trader starts losing, he starts taking more risks and get into a downward spiral difficult to leave. this is why banks and academia should be more proactive and integrate the essential psychological dimension in different university courses but also in continuing education. It is only through this work of education that we can, not eliminate all fraud, but reduce their occurence.

Maxime Onan October 2011

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[1] It is estimated that this pain is twice as important as the satisfaction derived from a similar gain.




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