What is Trading 'Risk Type'? Why is it getting so much attention?

With the arrival of the Senior Managers Regime, and other conduct risk regulations due to start soon, the use of objective scientific tools and methods for understanding the nature of the people within trading roles is starting to get a lot of attention. The 'Risk Type Compass' is one such tool. In this article co-authored by Geoff Trickey, Managing Director at Psychological Consultancy Ltd (PCL), and Steven Goldstein, Trader Performance Consultant at Alpha R Cubed, they look at risk type, why is it so valuable and how companies are using this concept to help them build a stronger risk culture, and improve business performance.

In trading, as in everyday life, it is implicitly recognized that people vary considerably in their risk-taking behaviour. Yet, surprisingly, personality has often been overlooked as a critical force on risk behaviour. So what do we mean by personality 'Risk Type' and why can it be so empowering in helping to improve your trading performance? 

Let’s first draw on a powerful analogy. Consider a boat on the sea with its anchor down. The boat moves around on the surface as it gets pushed, pulled and buffeted by the tides, wind, and waves. However, there is a defined point around which these movements are constrained. This analogy parallels the relationship between Risk Type and Behaviour. Risk Type, like the anchor, has a persistent and continuous influence. In effect, a person's Risk Type establishes a consistent bias that influences all risk-related decisions.

 The mistake in the past has been to think of risk-taking behaviour as something that falls somewhere on a scale between risk aversion and gung-ho recklessness. In fact, risk-taking relates to many different aspects of personality such as distractibility, impulsiveness, pessimism, uncertainty, over confidence, inflexibility, fearlessness, or a tendency to overreact or be unresponsive. These and many other risk-related characteristics from the personality domain have been factor analysed and regrouped to build the Risk Type Compass.

The Risk Type Compass

The 'Risk Type Compass' helps people to gain deeper insights into their risk personality and how it impacts their decision-making in high-risk situations.

One pole on the Compass defines a personality disposition that is extremely alert to risk and emotionally aroused to action by it. If you are predisposed this way you are likely to be anxious, apprehensive, and fundamentally pessimistic so that anything unfamiliar or ambiguous will be perceived as a threat until proven otherwise. Your reaction to risk is visceral, strong, passionate, and expressed physically as high arousal and avoidance, more tuned for flight than for fight.

If you fall at the other pole of this first scale you would have opposite characteristics: an unusually high threshold for perceiving risk, an unemotional response to it, and a greater readiness to take risks. Your optimism leads to anticipation of positive outcomes, new possibilities, and opportunities. Consequently, you may be the last to appreciate the danger. Disappointments, upsets, or failures arouse little emotion, no regrets, disparagement, or remorse. Your willingness to take it down to the wire before bailing out will open doors to opportunities that would otherwise have been missed.

The second of the two bi-polar scales is concerned broadly with restraint at one end and impulsivity at the other.

The first pole is characterized by the need to understand, to make sense of things, and to prepare appropriate and suitable actions, carefully and in detail. If you are predisposed this way you will be reluctant to do anything until you see good reason to do so and unless you have a clear and well-prepared plan of action. You are likely to be conservative, conventional and respectful of tradition and would ideally organize risk out of the equation.

The opposite pole of this second scale is concerned with excitement seeking and impulsivity. If you score at this extreme you will be easily bored, preferring the new to the familiar and the unconventional to the traditional. Because you enjoy and embrace uncertainty you are more comfortable about doing things ‘on the fly’ than planning events carefully or in plenty of time. Restless and easily bored you seek action, welcome change, and may be frustrated by traditions and conventions that stand in your way.

The Risk Type Compass places people into one of eight different Risk Types based on their scores on these two underlying scales.

Risk Behaviour Change Requires an Understanding of Risk Type

From a trading perspective, understanding your Risk Type helps you make sense of the positive and negative behaviours you display in your trading activities. For example, individuals identified as extreme ‘Wary’ types tend to be highly risk-averse. They are usually very detailed orientated and highly analytical, and are therefore more likely to succeed taking a tactical approach to trading. On the other-hand, Wary types may display high levels of anxiety and find ambiguity challenging.

Diametrically opposed to the Wary type is the 'Adventurous’ type. These individuals have a high-risk tolerance and are more likely to succeed adopting a strategic perspective. They are comfortable holding risk without becoming too flustered. However, they lack detail orientation and can get caught out being over-confident and under-appreciating the level of risk they take.

What matters for success is not which Risk Type you are, but whether you apply yourself in the correct way for your Type. The most profitable trader assessed by Alpha R Cubed so far was an extreme version of the Wary type. This individual was from a large and very successful hedge fund. He was very anxious and nervous when trading yet he produced profits well in excess of $100 million over each of the past two years. His method, which is purely discretionary, plays very much to the strengths of his Wary characteristics.

Applications in Financial Markets.

Alpha R Cubed have carried out extensive research with traders and risk professionals from banks and hedge funds. This research is proving hugely revealing at identifying the most appropriate risk type characteristics for certain types of trading. Distinct differences are showing up in the risk-type characteristics of market-makers, directional and short-term proprietary traders, relative value portfolio managers, options traders, people in execution roles. This sort of insight is dynamite for firms looking to select the right people for certain roles. Typically, trading firms hire quite arbitrarily, selecting candidates based on what they believe is the right sort of make-up for a generic trading role. As an analogy, this is akin to choosing a generic ideal of how an athlete should be, rather than looking at the specific body types for the various types of athletic disciplines.

As an example consider the role of an execution trader at a large macro hedge fund. In many funds, the portfolio managers are often (though not always), slower and more considered in their approach to execution. This can lead to some clumsiness in placing large orders and leads to high slippage costs. Thus large funds will often have their own execution desk who specialise in transacting orders. Their skill in doing so can reduce slippage costs and make it more likely to successfully execute and exit large positions, particularly when it comes to relative value trading. Our analysis has found that the ideal risk type for an execution trader is very different to that of a typical relative value trader. One hedge fund has suggested that the difference in performance of having the appropriate type for an execution role may be worth around $20 to $25 million per year to them alone in slippage reduction.

Likewise, the knowledge of risk types can impact how successfully firms train and develop their people. Much of the training in banks and trading firms occurs by placing a novice trader with more senior traders. However, if for example the novice trader is the composed type, and the experienced trader is the intense type, then this is likely to lead to sub-optimal learning experience for the novice. Again as an analogy, it would be like a sprinter mentoring a long distance runner. They will be learning a trading style completely inappropriate for them. This can be a highly demotivating experience, and leads to a waste of talent. In our work we have come across traders who have been in a role for 10 years or more, but are using a style ill-suited to their needs. Often when we help them realise that there is an approach more suited to them, and we coach them to adjust to a new style, their performance can soar. Our article featured here, highlights some examples of Alpha R Cubed’s work in this area.

 

The tool also has extensive application in the area of ‘conduct risk’ which is a red hot topic right now. In the UK, the ‘Senior Managers Regime’ has recently come into force. This regulation is grabbing the attention of bank’s senior managers who are now personally accountable and liable for ‘conduct risk’ failings in their areas of responsibility within their firms. Under this regulations, senior managers could face criminal prosecution and personal financial liability, even if the failings occur after they leave the firm for up to 6 years after their departure. Thus suddenly the importance of having the most appropriate people, in the right roles, is not surprisingly getting their attention.

The Risk Type Compass also has many applications beyond improving trader and investment manager performance. It is increasingly being applied to help improve team, leadership, and management performance, as well as to support cultural initiatives and change projects in banks and investment firms. The tool is also being used with boards and strategic decision-makers by consultants and coaches, as well as in the world of high-performance sport.

Risk Type as a driver of Risk Behaviour.

While various factors influence our behaviour, they are intermittent and will vary. We have goals and aspirations, as well as free will in dealing with an infinite variety of situations, but our risk-taking is anchored by personality dispositions that underpin our unique personal preferences and limits. Understanding your Risk Type helps you to maximize your strengths in your trading strategies rather than working against the tide of your natural risk disposition.