Nick Leeson – King of the Rational Emotional Decision Makers

Nick Leeson is a working class lad made good. Then made bad. Then made good again. His story is famous the world over. He is the man who brought down an entire bank. Exactly how this was allowed to happen is of course a Black Swan in itself but it did and the fallout was immense, not least for Leeson himself who ended up in a Singapore jail for several years before laudably coming back with a vengeance and writing a book about his recovery and the effect that stress can have and how to beat it.

The exact details of what happened in 1995 are obviously complicated but essentially the principle is exactly as the world understands it: by the end of 1992, the amount concealed in the error account was £2m, but the end of £1994 it was £208m and by 23 Feb 1995 Leeson fled the country leaving a note saying “I’m sorry” and an account which held £827m in losses. Essentially, Leeson had got caught in a spiral of loss partly due to his decision to use a system to try and correct what began as fairly modest errors.

The system – known as the Martingale system – is known to gamblers and traders the world over and must be the cause of more unhappy nights in Vegas than any other. Essentially, it says if you lose your first bet (of, let’s say $1) you simply double it on the next spin, or hand, and if you lose that, simply double it again and so on and so on until you, eventually win, as you eventually must. The inherent problem with the system is that in theory it works perfectly. At some point within an infinite period of time, however, the monkey on the typewriter will bash out the works of Shakespeare or at least a sonnet or two! What the laws of probability don’t say, however, is WHEN! Which means that an infinite bankroll is required to make the system work in practice, something that even Warren Buffet doesn’t have. And neither did Barings Bank!

But here’s the question: why – when he was £100 million pounds down, did Leeson – an apparently intelligent, determined young man keep going? Why not throw in the towel, concede defeat and do the time that he was ultimately sentenced to do? Why push the envelope until the point of no return and potentially destroy everything for everyone in the process.

The answer lies in the meanings or values that Leeson placed on the different possible outcomes of the potential opportunities available to him.

The only thing that meant anything at all to him at that point was just breaking even. Reducing the losses to £70 or £40 million meant nothing. He was still going to lose his job and almost certainly go to jail in this eventuality. Increasing the losses to £200, £300 even £400 or £500 million was not going to worsen the situation for him really. He had got to a stage where the downside remained the same and the meaning of the upside (his possible reward) was everything. Effectively doubling through and breaking even meant safety, it meant freedom, it meant employment, it meant an end to the stress which eventually gave him cancer. It meant getting the life he loved back.

In this way Nick Leeson was no different to the millions of gamblers who step inside the billion dollar casinos in Las Vegas or Sun City or Mayfair or anywhere around the world. Largely otherwise intelligent, rational people make decisions for an evening which deep down they know will cost them money. People who play slot machines, for the most part, know deep down that the house will win in the long run. I’m not saying that there aren’t people in those places who become convinced that they are “hot” or that they have a “system”.

For Nick Leeson, whatever the probability of the downside, the meaning he placed on losing even more money was minimal. The only thing which meant anything at all to him was breaking even. This was immoral, certainly, given the consequences of his actions for thousands of people but rationally… well, rationally it made sense! Given a similar lack of moral fibre any one of us might well do the same in the same situation.

Certainly given a different situation which, for example, forced us to make a decision to do something which might kill us but which might also very well save the life of our child, which mother or father would not take this course of action? Naturally, this is a hypothetical situation with no detail at all and the first thing you would want to know would be the probabilities involved – but we’ve already covered that. The point is that the meaning we place on the possible upside as a parent would far outweigh the potential downside. Somewhat morbidly, in order to more closely simulate Nick Leeson’s emotional calculation we would probably have to assume that we were likely to die in either event – a factor which would make the ultimate decision a no-brainer.

The situation that Leeson found himself in was very different to going into a casino with £50 (or even £50 million like Kerry Packer did) that you’re happy and prepared to lose. It’s more akin to the position that the poor sap who has heard about the Martingale system finds himself in after maxing out two credit cards in a desperate bid to win back that first $10 after a statistically freakish but eminently possible 10 spin losing run (1024 -1 against). Now, we are anything but happy. We are anything but prepared. But in much the same way, if for very different reasons, there is very little additional pain we can experience. It’s not just our credit cards that are maxed. So are our pain levels. And the only way is up.

Posted 02:47pm by Caspar and filed in Decision Making, Risk

Life’s not fair

“That’s not fair” I cried as my friend completed his set of Vine St, Marlborough St and Bow St that would eventually lead to victory that evening.

I wouldn’t have minded of course had he completed the transaction fairly and squarely but the deal was sealed with the offer of both four hundred pounds of monopoly currency and twenty pounds of actual sterling! “That’s cheating,” I shouted again. And thus began an argument which still rages to this day, twenty years on. To me, there is no debate; what he did was outside of the rules of the game. It was cheating.

I was reminded of this experience recently when, in April of this year, the FBI seized the URL addresses of the two biggest online poker sites, Poker Stars and Full Tilt. The action finally brought an end to their US operations five years after the uncertainty initially created by the Unlawful Internet Gambling Enforcement Act of 2006.

Some have viewed this definitive action to be a good thing, but the unacceptable sting for many players active on the sites at the time is that whilst Full Tilt had a reported $400m in players’ funds it only had $60m in the bank – apparently placing its faith in a kind of fractional reserve system of deposits that is likely to leave thousands of players nearly bankrupt.

“That’s not fair” they have understandably cried as two of the site’s founders are alleged  to have taken dividends of tens of millions from the site leaving the vast majority with almost nothing to show for years of play/work!

Interestingly, while what has happened is almost certainly illegal, and therefore obviously much more serious and profound than a bit of cheating at monopoly, the central problem is very similar: what happened took place outside the basic rules of the game. It still happened, however, and no amount of shouting or complaining is likely to change that fact.

The common perception of poker is that it is broadly a game of epistemic risk. Complete novices sometimes think that it is a game of deductive logic, like blackjack, that starts and ends with the likelihood of a particular card coming down. After playing the game for even just a few hours, however, it is clear that this is only a very small part of the story and that in practice playing the game involves making a series of inductive assessments about our opponents – assessments which get better with experience that leads to greater accomplishment and expertise.  In this respect, the decision-making process of poker is very like that of any other realm of life.

Where poker is unlike life is that often you are forced to make such a decision every 90 seconds or so. Given that you cannot abdicate, delegate or procrastinate during the process of making them, they are even less like a lot of the decisions we make in life which are often left unaddressed for as long as possible! Similarly, the decisions we make in poker are often very one dimensional, focusing merely on the allocation of money, in the form of poker chips, for the purposes of accumulating more in the long term. There is rarely any consideration of society or the greater good of those around you which ultimately is why I stopped playing professionally.

But where poker is exactly the same as life is that – despite a recognized set of rules by which the game can be played reasonably and fairly on a daily basis – from time to time those rules will be breached. Often, such a contravention will be unfair to one or more parties: people may lose money, in the real world they may lose things much more valuable and precious.

In The Black Swan, Taleb defines the “Ludic Fallacy” as the misuse of games to model real-life situations, but in actual fact both are a perfect metaphor for the other and Taleb goes on to say as much. Each has a set of rules which – if and when adhered to – make their play relatively straightforward and enjoyable. In games, however, people cheat and poker sites go under and in real life governments default and whole currencies collapse.

He creates the hypothetical situation of a “fair” coin being flipped ninety nine times and coming up heads every time. Two fictitious creations of the author – Fat Tony and Dr John – are asked for the chances that the next flip will also bring up heads. Dr John’s answer: “obviously fifty-fifty, independent events have no bearing on each other”. Fat Tony: “near enough one hundred percent heads” on the grounds that any coin that flips heads ninety nine times straight is obviously biased.  In other words, just because a game appears to have rules, doesn’t mean that they are – or always will be – adhered to.

(And even if they are, the probability is never an objective 50% Actually the uncertainty principle reigns even here as Dr Jeffrey Hamilton demonstrated accidentally in October 1972 when in a lecture on probability in the University of Warwick he tossed a 2p coin and was astonished as everyone else to witness it land on its edge!)

The effect of such a consideration in the game of poker has the interesting effect of making it much more a game of aleatory or unpredictable – some might say unquantifiable – risk. The probability that the next card is an ace is arguably far less significant in our overall calculations than the chances that the game we’re playing is somehow rigged, or the likelihood of being robbed on our way to the carpark or the probability that the website on which we’re playing doesn’t actually have our money in it, or… who knows what?

When such breaches occur, we may feel aggrieved; we may be moved to protest; we may seek revenge and we may be justified in any and all such responses. But, hopefully, there is one thing we know for sure above all else… from time to time such things will happen. They will. Life… is unfair. And any long-term strategy that does not account for such possibility must surely be inherently flawed in some respect. If we play the game assuming that nothing unfair and outside the rules of the game will ever happen then we’re not playing the game particularly well.

The only question is what will we do in response? Will we have factored such events into our analysis and strategy? Or will the memory of such events still hurt twenty years on?

Posted 01:01pm by Caspar and filed in Decision Making, Uncertainty

Utterly Incredible

If the future wasn’t inherently uncertain then every decision that we ever make would be easy. We’d know exactly which employee to hire, which house to buy, which meal to eat, which hand to fold, which pension plan to invest in, which route to take to work, which boy to kiss, which horse to bet on and what’s inside the box. Life would be very different. Fundamentally, unrecognisably so in fact. Tragically, or fortunately, this is not the world we live in. Continue Reading »

Posted 10:50am by Caspar and filed in Uncertainty