How to Lose Money in the Financial Markets: Examples from the Recent Financial Crisis

What makes financial institutions, banks and hedge funds fail? The common ingredient is over betting and not being diversified in some bad scenarios that can lead to disaster. Once troubles arise, it is difficult to take the necessary actions that eliminate the problem. Moreover, many hedge fund operators tend not to make decisions to minimize losses but rather tend to bet more, doubling up, with the hope to exit the problem with a profit. Incentives, including large fees on gains and minimal penalties for losses, push managers into such risky and reckless behavior. We discuss some specific ways losses occur. To illustrate, we discuss specific cases from the recent financial crisis, including Societe Generale and subprime mortgages. We also list other hedge fund and bank trading failures with brief comments on them.