How to Keep Rogue Trades Out of Your Investment Portfolio

The parallels to 2008 keep piling up.

Early that year, French bank Société Générale revealed $7.2 billion in losses (that’s billion with a “b”) at the hands of a single rogue trader. The culprit: A 31-year-old trader named Jerome Kerviel.

The Société Générale losses came on a massive $73 billion worth of positions, which Kerviel hid by hacking the bank’s computers. After that devastating hit, SocGen instituted a whole new slew of watchdog rules, such as “be wary of traders who never use vacation time.”

Now, in 2011, another major bank — the Swiss bank UBS — has announced a cool $2 billion in surprise losses. A “rogue trader” has struck again.

This time it was not Jerome Kerviel in Paris, but a UBS employee named Kweku Adoboli in London, who did the damage.

The similarities are uncanny: Both Kerviel and Adoboli were 31 at the time of their arrest; both worked with “Delta-1″ products (a form of derivative that tracks asset classes); and both appear to be quiet types who toiled in similar departments.

The $2 billion rogue-trade loss is another black eye for the banks, which were supposed to have stamped out this sort of thing with much tighter fail-safes and controls.

“It is amazing that this is still possible,” muses trading analyst Claude Zehnder. “They obviously have a problem with risk management…”

For individual investors and traders, one lesson here may be to avoid “black boxes” — opaque businesses with complex structures, like banks, where something big could go haywire at any given time.

But the incident also provides food for thought. How do these trading disasters come about?

Men like Adoboli and Kerviel, and other rogue traders like Nick Leeson of Barings Bank (who lost $1.3 billion) or John Rusnak of Allied Irish Bank (who lost $691 million), do not intentionally set out to blow things up.

Instead, the trouble usually starts small… an attempt to cover up a modest investment portfolio loss, or to make a poor reporting period look better.

The goal becomes to make a little extra money quickly — enough to cover the small problem — and then go back to normal, with no one the wiser.

If the double-down scheme works, the trader’s name never shows up in the news. He (or she) may even earn a nice bonus at the end of the quarter.

But if it doesn’t work, and the initial loss snowballs, that’s when the real trouble begins. As problematic losses become too big to manage, desperation kicks in. Bigger and bigger bets are made, until finally it all unravels.

On a much smaller scale, the same thing can happen to an individual investment account. Not the fraud part, per se, but the compounding disaster from a “rogue trade.”

In this instance, a small loss is allowed to morph into a bigger one… a bad investment is ignored, or even added to on margin… and so on. You know the rest of the story.

Here are some rules of thumb for keeping “rogue trades” out of an investment portfolio:

• Always know your exposure.
• Always know your risk points.
• Don’t buy more without a plan.
• Don’t forget correlation.

Always Know Your Exposure

This one is simple but important. How much risk does your investment portfolio actually have? And how is that risk spread out across positions?

If you are 50% long with all your money in two stocks, for example, that is a different proposition than having your money in 20 stocks. If you have short positions or inverse ETFs to offset some of your long exposure, that changes the picture too.

Tracking exposure levels helps clarify the danger you might face in a “worst-case scenario.” It’s not always fun to think about, but better to be prepared than unprepared.

Always Know Your Risk Points

Next: If a position goes against you, where is the risk point? That is to say, at what point will you sell it (or cover if short)?

There are many possible approaches here: A trader might prefer a tight stop-loss based on a chart pattern. An investor might utilize a general risk point, like a 25% stop-loss. An aggressive value investor might say, “I like this position so much it could go down 50% and I wouldn’t sell.”

The key thing is having a risk plan beforehand — and then sticking to that plan. If you buy a stock with no sense of where you might sell, you secretly imply a willingness to hold to zero.

And if you really are willing to hold on no matter what — assuming the fundamentals still look OK — then clarify that to yourself up front. It will push you in the direction of smaller position sizes, and encourage treating the entire holding as your risk amount.

(For example: “I have 5% of my investment portfolio in XYZ, which I will hold… so even if XYZ goes bankrupt, the most I can lose is 5%”).

Don’t Buy More Without a Plan

There is a great divide between traders and investors when it comes to “averaging down” — the process of adding to a long position as price declines (or adding to shorts as prices rise).

Most traders rarely if ever average down. Some value investors swear by it and do it regularly.

For the trader, a position moving too far the wrong way is a clear sign the timing was wrong. For the value investor, it is just a sign their cheap investment pick is getting cheaper! Traders and investors are also willing to add more as a position moves in their favor. This is often known as “pyramiding.”

No matter the circumstances, a decision to add to the position (via pyramiding or averaging down) should be planned out in advance, before emotions get involved.

This is what the rogue traders failed to do; they let emotion get in the way, and then they lost control.

Don’t Forget Correlation

And finally, don’t forget correlation risk. The more capital you have committed to a single industry or group, the greater the correlation, in terms of price moving up or down on the same drivers.

For example, seven different steel stock positions may actually act like one steel stock position, seven times as large. Three bullish grain trades may act like one bullish grain trade three times the size, and so on.

On top of that, it takes little reminding these days that risk assets have become more correlated in general. This is the idea behind “risk on” and “risk off” market conditions, in which the thundering herd runs full blast in one direction or the other.

With those basic rules at hand, your trading and investment portfolio should happily stay “rogue free.”