I have known it for a long time, staring at the screens makes me see movements which are not actually there. Like the optical illusion of the two arrows, the illusion is always present even though I know the lines are the same. Try as I might, I cannot get my brain to correct its error and it will continue to trick me into my old age. It does me no harm though because I know that I am seeing an illusion and my brain is playing a joke on me. I know they are really the same length so no harm done. Closely related to this is the Waterfall Effect, newly recognised by academics, which is a hard-wired effect for those looking at their Bloomberg or Eikon terminals to see movements that are not there.
I use this familiar optical illusion as an illustration during my behavioural finance talks for the Charter Institute for Securities and Investment CPD talks and my courses for traders. I explain how we are hardwired to make the mistake – bias – and cannot control it. But no accidents occur because we know we are seeing an optical illusion. According to new research, published in the journal Current Biology, the perceptual bias that comes with prolonged exposure to stimulus can be as readily applied to markets and traders as anything else. The research, by academics from the University of New South Wales, Swiss Finance Institute and University of Geneva, found that just as someone watching a waterfall for a while begins to see the rocks around it moving up rather than the water down, so too, market-watchers in front of a Bloomberg or Eikon screen might lose perspective. ”Our findings point to a complementary root cause, an adaptation to chronically high levels of risk and subsequent risk blindness,” the study’s author, Dr Payzan-LeNestour, said.
The team arrived at this link via a number of tests. In one, 56 test subjects are exposed to 50-second periods of Bloomberg/Eikon terminal -style market stimulus, split evenly between moments of high volatility and moments of low volatility. Each exposure period was immediately followed by a test phase comprising 20 seconds of medium volatility. Participants were then asked to rate the perceived volatility of the test stimulus on a five-point scale, using the medium volatility as the baseline. Those exposed to high volatility saw less difference between that and the base period, while those exposed to low volatility saw more of a gap. The study’s author and UNSW Business School senior lecturer, Elise Payzan-LeNestour, said the research may help to explain rogue trading, which is usually attributed to a heightened appetite for risk, inadvertently encouraged by management oversights and regulatory pitfalls.
I stare. I see movement which is not there. I know it. I adjust my thinking and trading to adapt for the hard wired illusion. I hope you do the same. It comes with experience. But, at its extreme the Waterfall Effect can have terrible consequences if not understood by traders themselves, their risk managers and compliance people. It is this effect – this heightened appetite for risk – which has been at the route of all the major rogue trader events. None related to fraud or theft. They were all cases of traders gone mad.
|Jérôme Kerviel||Paris, France||2006–2008||$6.9 billion (€4.9 billion)||Société Générale||European Stock Index Futures||5 years prison of which 2 years are suspended, pending appeal|
|Yasuo Hamanaka||Tokyo, Japan||1996||$2.6 billion||Sumitomo Corporation||Copper||8 years prison|
|Kweku Adoboli||London, United Kingdom||2011||$2.3 billion||UBS||S&P 500, DAX, and EuroStoxxFutures||7 years in prison|
|Nick Leeson||United Kingdom||1995||$1.3 billion (£827 million)||Barings Bank||Nikkei Index Futures||6.5 years prison|
|Toshihide Iguchi||Osaka, Japan / New York City, United States||1995||$1.1 billion||Resona Holdings||U.S. Treasury Bonds||4 years prison|
|Boris Picano-Nacci||Paris, France||2008||$980.3 million (€751 million)||Groupe Caisse d’Epargne||Equity Derivatives||€315 million fine (2yearsuspended sentence)|
|John Rusnak||Maryland,United States||2002||$691 million||Allied Irish Banks||Foreign Exchange Options||7.5 years prison|
|Chen Jiulin||Singapore||2005||$550 million||China Aviation Oil||Jet Fuel Futures||4 years and 3 months prison|
|David BullenLuke DuffyVince FicarraGianni Gray||Melbourne, Australia||2003–2004||$187 million (A$360 million)||National Australia Bank||Foreign Exchange Options||3 years and 8 months prison2 years and 5 months prison2 years and 4 months prison16 months prison|
|Matthew Taylor||United States||2007||$118 million||Goldman Sachs||S&P 500 e-mini Futures|
In none of the notable cases above did the individual plot to steal or defraud their institution. They were taken over by some trader madness. In all cases the madness was induced by the Waterfall effect – a heightened (at the extreme) appetite for risk. In their minds what they were doing was normal.
Trevor Neil MCSI MSTA
Fist published at www.betagroup.co.uk/blog