SAC Capital and the allure of the easy win

July 23, 2013: 11:30 AM ET

A myopic focus on risk can lead even hyper-logical traders down a path toward illegal activity.

By Ethan Rouen

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SAC Capital's Steven Cohen

FORTUNE -- As the SAC Capital case sputters and chugs and the government continues its crusade against insider trading, the question to keep asking is, "why?" Why on earth do hedge funders who have enough money to use Picassos as napkins take such unnecessary risks by acting based on illegal insider tips?

Is it hubris, stupidity, or, oddly enough, the same risk measurement tactics they have been taught to use their whole life?

Spend five minutes with any investing geek, and you realize that he looks at risk in a way that is vastly different from the rest of the population (many of whom don't seem to think much about risk at all).

In most cases, this quality has been ingrained in the best professional investors; that's why they chose to major in accounting at a state school versus studying binge drinking and French poetry at Harvard. The long-term price-to-value ratio was significantly lower on the first option, and even as hormonal 17-year-olds, they made decisions based on this philosophy.

Obsession with risk makes committing a crime like insider trading baffling, especially for those who run funds and can afford to avoid such risk. So think about how high the upside of such a bet must be that the real possibility of sacrificing one's career, wealth, and freedom doesn't squash it immediately. Indeed, it is precisely this kind of myopic focus on risk that can lead hyper-logical traders down a path toward illegal activity.

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SAC has a quantitative desk and, like many hedge funds, it can make serious cash trades on tiny market inefficiencies in the milliseconds before they are priced out. The payoffs are small, but when the wagers are big, these low-risk bets can deliver a comfortable return.

But insider-trading cases are good examples in which strategies based on big data fall short (there are several others that played a role in the 2008 financial crisis). The promise of extraordinary returns can prove all too alluring, even for the risk-obsessed trader. That is likely why billionaire hedge fund mogul Raj Rajaratnam is sitting in jail. And it is why eight current and former SAC employees, including founder Steven A. Cohen and the two subordinates he allegedly failed to supervise, have been charged with engaging in insider trading.

Without a doubt, greed and ego played a significant role in their decisions, but these people spent their careers placing bets with varying degrees of certainty. A sure thing throws their ability to quantify risk out of whack and has so far cost SAC $3 billion in capital from investors who have withdrawn from the fund.

At this point in the case against SAC, it's surprising that some of those charged haven't recalculated the risks in their current situations, like Richard Choo-Beng Lee, who started cooperating with the government in 2009 (three others have pleaded guilty or reached a civil settlement).

When proper risk measurement means the difference between being a billionaire and being broke, one starts measuring risk in every choice, be it an exercise regimen or where to send your child to pre-school. A good investor would attempt to track as many alumni of that school as possible. He would look at graduation rates, reading and math levels upon graduation, and success all the way through college and into careers. He would also attempt to see how long teachers tend to stay in their jobs and whether his child is likely to get along with the other children.

Basically, a good investor is a data junkie, one who looks to gather every possible piece of measurable information before making an investment. This information comes from S.E.C. filings, but it also comes from commodity prices, supplier interviews, what employees say on the Internet, and countless other sources that are legally available. The more one knows, the lower the risk and the greater the confidence in the price-to-value ratio.

There is an amazing amount of information available to those who are willing to dedicate the time to gathering it. As computing power grows, digesting that information for useful purposes becomes easier and more reliable.

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The pre-school example isn't unrealistic for the most neurotic of parents, so what if there was an illegal way to obtain a recording of a teachers' meeting in which all the teachers decided they would be leaving the school after this year? All the other information becomes instantly worthless.

That is the allure of an inside tip. It's not that big data isn't an effective way to build a trading strategy (or a marketing or management strategy). With the massive amount of data available, and the improving ease with which even amateurs can use it to guide their decisions, data science will continue to be a growing part of many aspects of business.

But personal connections and stepping away from the screen can provide insights and facts that are significantly more valuable than what the data tell us. So valuable, in fact, that one big bet may seem worth risking everything.

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