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Bernie Madoff Investing Lessons: How Rogue Traders Can Immunize Your Wealth

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Bernie Madoff died this week and I'm writing about him today for the same reason I did in 2008 before I ever heard his name.

That reason is to help traders and investors develop discipline that the "rogues" of finance are never willing to.

Before Madoff made-off with their money, I had been studying rogue traders for about 13 years, ever since Nick Leeson took down Barings, the oldest bank in England.

Now there is certainly much blame and punishment to be handed out to financial finaglers. But when you or I copy their behaviors by lying to ourselves about losses, we only hurt our own accounts.

"Wait," you say. "The criminals are motivated by greed to steal, or destroy, the wealth of others. That's not me."

But I say it's the same human thinking and behaviors of greed, ego, irrationality, and sloppy math that destroy our own wealth as those that "take down the bank."

What Can We Learn from Aviators?

In the video that accompanies this article, I reacquaint you with my research and philosophy that "your brain wasn't made to trade." This belief came from my first-hand research on the trading floors of Chicago, plus exploring the important literature from neuroscience and and behavioral finance.

You don't have to share my belief, but either way it can lead you to one serious conclusion: serious focus on training your brain is the solution to safe and consistently profitable trading.

I have such a strong bias about proper training that can handle risk and contingencies because I was trained to fly an airplane as a teenager and got my pilot's license at 18.

So I also share a bit in the video about a greater man who also left us this week and what he taught me about life and markets. My Dad was 87 and had an amazing career as an aerobatics pilot and captain of Boeing (BA - Free Report) 747s for United Airlines (UAL - Free Report) . He was also my first flight instructor.

You can read that story here along with an 18-min audio version where I dive right into the pilot training that can benefit all investors and traders...

Flight Plan for Trading: Market Lessons from My Pilot Dad

In that piece, I also talk about how exciting it was to show my Dad all that was happening with the newly reinvigorated space program as private entrepreneurs and enterprises like Elon Musk with SpaceX and Jeff Bezos with Blue Origin were taking the lead and collaborating with NASA. Here's an excerpt from that piece...

Growing Up with Wings and Space

According to my big brother Rory, Eugene "Ole" Olson joined the Experimental Aircraft Association (EAA) in 1968 and purchased a 1941 Clipped Wing Piper Cub. He flew competition aerobatics with the Cub and won the International Aerobatic Club (IAC) Sportsman National Championship in Fond du Lac, WI in 1972. Later the same year he won the ACA Sportsman National Championship in Dennison, TX.

These achievements were the first, in the same calendar year, by any aerobatics pilot ever. This earned him a listing in the record book, Who's Who in Aviation. During those years he taught his teen sons, Rory and Randy, to fly. And he liked to take me upside down in the Cub whenever possible. It was scary and stomach-churning when I was young.

Yet I couldn't help but trust and admire him for those amazing skills. When I turned 16, he also taught me to fly -- after he taught me what hard work was around the house and at the local airport. More on my flight training coming up.

Prior to that, I grew up with visions of rockets and space. Dad and I watched every NASA mission like it was the last thing happening on earth. I cut out every picture and article I could find about the space program from newspapers and aviation magazines. Going into space, toward the stars, seemed like the ultimate, magical mission for me.

I never pursued those dreams, but they live within me and I look for every opportunity to inspire youngsters to study science and math and reach for whatever stars ignite their curiosity. I also have a project in mind to help underprivileged kids take a free flight ground schoolcourse and then earn the chance for a flight instruction scholarship. Contact me if you have any interest in such a project for your community.

In the past couple years, I've shown my Dad videos of SpaceX, Blue Origin, and Virgin Galactic (SPCE - Free Report) rocket and orbital technologies because I knew he wasn't getting to see all this magic just from his TV.

Over the years at Oshkosh EAA fly-ins, Dad had likely met the Rutan brothers of Scaled Composites who were instrumental in designing, building, and testing advanced, experimental aircraft and who eventually won the Ansari X-Prize in 2004 for SpaceShipOne, thus attracting the dreams and wealth of Richard Branson.

I do wish I had more time with him near the end to share all that's happening in the space industry, that will probably soon become its own sector with all the innovation and investment.

The new ARK Space Exploration & Innovation ETF (ARKX - Free Report) could soon be worth many billions in AUM, even without owning any of the still-private SpaceX -- which could be valued as much as $75 billion. Meanwhile, Morgan Stanley researcher Adam Jonas projects the global space industry could generate over $1 trillion in revenues by 2040.

Now here's an excerpt from my opus magnus on training your brain to trade...

Mental Models of Financial Sabotage

In July 2008, I published my first article about trading and investing in a small industry magazine called SFO (for stocks, futures, and options). I had been working for five years on an idea based on three big areas of interest: trading success and failure, behavioral finance, and neuroscience.

My thesis was that "your brain wasn’t made to trade." I came to this conclusion because of the intersecting knowledge from these three areas. First, I learned about trading as a clerk on the floors of CME Group (CME - Free Report) , from becoming a professional currency trader myself in 1999, and from reading dozens of invaluable interviews with trading legends like George Soros and Paul Tudor Jones from Jack Schwager's Market Wizards books.

My experience of trading, and of many other traders, gave me certain ideas about why so many failed in what was arguably one of the most mentally and emotionally-challenging "day jobs" around. The primary observations revolved around traders getting overly emotional and making bad decisions, driven by greed, fear, envy, regret, anger, despair, and immature ego/instant gratification needs.

I concluded that what was missing for most traders who let emotions override sound rules and discipline with money and risk was one of the top lessons from the Market Wizards: probability-based thinking. And since this was an area of weakness for me in high school and college, I decided to commit to teaching myself probability and statistics in my 30s.

What the Rogue Does to a Billion Dollars...

But one group that even probability training might not help were the so-called "rogue" traders, who could destroy a billion dollars faster than you could spell statistics. I collected and studied these stories, like Nick Leeson who took down one of the world's oldest financial institutions in 1995, Barings Bank.

Then there were the "geniuses that failed" at Long-Term Capital Management, headed up by Nobel prize winners. These guys weren't rogues, but what's the difference when that $3.6 billion wipeout in global interest rate bets-gone-bad, during the financial crises of 1997 and 1998, saw the Federal Reserve step in and orchestrate one of the first "too big to fail" bailouts. Funny how that amount became peanuts only ten years later.

When I published my 2008 article, we had just witnessed the largest rouge trading debacle ever: French trader Jerome Kerviel cost Société Générale nearly $5 billion euros with his excessive risk-taking and covering-up of bad trades. (He says he did not work alone and that the culture of the bank was prone to excessive risk-taking, but that's a good story for another time.)

I had two important conclusions regarding rogue traders. First, we have a lot to learn from them because, as you'll see when we dive into the twin sciences of our irrationality, what the rogue trader can do to a billion dollars of OPM, we can do to our own investing and trading accounts. Second, I said rogues would always happen again, no matter how much regulation or oversight.

Six months later in December of 2008, we learned of Bernie Madoff and his giant ponzi scheme that hurt hundreds of investors from Wall Street to Main Street, and didn't even spare Hollywood's finest like Steven Spielberg and Zsa Zsa Gabor.

And in a further ironic twist, the magazine publisher for SFO where my article first appeared, was caught in his own ponzi scheme. (That's one of the reasons I am trying to re-create it here since no online version is available.)

Russell R. Wasendorf, Sr. was the former Chairman and Chief Executive Officer of Peregrine Financial Group, a commodity broker that filed for bankruptcy protection in Chicago in July 2012.

According to Wikipedia, "He was arrested in July 2012 following a suicide attempt. In September he pleaded guilty to embezzling $215.5 million from more than 13,000 customers over the course of 20 years. On January 31, 2013 he received a 50-year sentence for fraud, effectively a life sentence."

(end of excerpt from "Mental Models of Financial Sabotage" from July 2008)

Learn from Bernie -- And from Ole

Be sure to watch the video here and get more details and insight on two influential men -- the infamous, destructive Bernie and the great, heroic Ole.

And the article version of Mental Models has tons more info on the neuroscience and behavioral aspects of training your brain to become a better investor-trader.

Thanks for joining me in Cook's Kitchen! Oh, in case you are wondering why the different last name than Ole, he took me and my little sister in as foster kids when I was five. That's how big his heart was.

Kevin Cook is a Senior Stock Strategist with Zacks Investment Research where he runs the TAZR Trader and Healthcare Innovators portfolios.

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