There's a Rogue Trader Threatening Your Portfolio

"A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise."
-- Daniel Kahneman and Amos Tversky

At first I wasn't at all interested in the story of Kweku Adoboli, the so-called "rogue trader" who cost UBS (NYSE: UBS) $2.3 billion. It all seemed very ho-hum -- a greedy Wall Street trader getting too big for his britches and losing a whole bunch of money when things went sour.

But then I realized that it's bigger than that. Much bigger. And it's something that all of us should take heed of.

As with any case like this, the truth will lie in some foggy gray area in between what UBS will say and what Adoboli's lawyers contend. I don't really care about whether what happened was legal or illegal, or how it could have happened from a risk-control perspective. What I am interested in is how somebody finds himself with a $2.3 billion loss in the first place.

Getting down with the disposition effect
From a psychological perspective, it's actually pretty easy. The behavioral-finance wonks long ago came up with a theory called the disposition effect. In basic terms, what it says is that most people are more likely to take risks when it comes to avoiding losses as opposed to when they're chasing gains.

For example, if given the choice between taking a sure $500 and a 50-50 gamble that, if won, would pay $1,000, most people will choose the sure $500. However, when given the choice between a sure $500 loss and a 50-50 gamble that, if lost, would cost them $1,000, people are much more likely to choose the gamble.

Or as Terrance Odean and Brad Barber put it in their 1999 paper:

[S}uppose an investor purchases a stock that she believes to have an expected return high enough to justify its risk. If the stock appreciates and the investor continues to use the purchase price as a reference point, the stock price will then be in a more concave, more risk-averse, part of the investor's value function. It may be that the stock's expected return continues to justify its risk. However, if the investor somewhat lowers her expectation of the stock's return, she will be likely to sell the stock. What if, instead of appreciating, the stock declines? Then its price is in the convex, risk-seeking, part of the value function. Here the investor will continue to hold the stock even if its expected return falls lower than would have been necessary for her to justify its original purchase. Thus the investor's belief about expected return must fall further to motivate the sale of a stock that has already declined than one that has appreciated.

In other words, investors tend to hang on to losing stocks much longer than they hang on to their winners.

The rogue trader in you
So how does this all tie in to our buddy Kweku? My bet is that he was taking some rather large risks to begin with, started seeing some of those positions move against him, and, rather than take the loss, kept doubling down on the gamble in hopes that he'd recoup the red. Textbook disposition effect.

But don't judge him too harshly. The behavioral-finance folks care about the disposition effect not because it's involved in these big, high-profile blowups, but because this behavior is the tendency of many, if not most, of us.

If that's the case, the next logical question is how we avoid falling victim to the disposition effect. Since I like numbers, one way that I'd suggest is to let the numbers guide you. Investors should all have some idea of what returns they're aiming for, and if they simply compare that goal with the calculated expected returns from the stocks they own, they'll know to sell the stocks that no longer offer a suitable return and hang on to the ones that do.

For example, a very simple way for dividend investors to get a basic idea of the expected return of a stock is to add the current dividend yield to the expected dividend growth. If that investor's targeted return goal is 12%, the following stocks would look attractive in today's market.

Source: Capital IQ, a division of Standard & Poor's.

Nota bene: As I mentioned above, this is a very simplistic way to calculate expected returns and is at best a starting point. But for the purposes of our 12%-seeking investor here, we'll say these are all good buys (or holds). The key, then, for this investor is to keep tabs on these numbers and be strict about cutting stocks loose once the expected return falls below that 12% threshold.

But be careful
Relying on the numbers entirely can be tricky if you're trying to avoid behavioral quirks. When using valuation or returns models -- whether complex or extremely simple, like the one in my chart -- it can be easy to plug in numbers to make the data seem to fit the conclusion you want to find. Those are all large, mature companies up there in my chart, and the historical dividend growth -- particularly in the cases of Walgreen and Intel -- may overestimate the actual future growth prospects. As you can see, if you add a few percentage points here or there, you can present a case that tells you that you should hang on to that losing stock because the returns are still attractive.

So while the numbers can help guide you, your true best defense against the disposition effect and becoming your very own rogue trader is simply to know that this quirk exists and may color your judgment. If you stay mindful of that, you have a better chance of avoiding cutting your best stocks loose too soon while gambling on a turnaround from your losers.

And now that we've gotten your emotions in check, there's nothing rogue at all about the five stocks in The Motley Fool's free special report "5 Stocks The Motley Fool Owns -- And You Should Too" -- they're simply solid stocks.