JP Morgan's loss: the ultimate risk adjustment

by Wayne Ferbert on May 17th, 2012

I think the loss from JP Morgan in its trading portfolio last week can teach investors a lot of lessons. One of the important lessons it teaches is: only risk-adjusted returns matter.

The Chief Investment Officer for JP Morgan lost her job because of the trades that made up these losses. Ina Drew was one of the most senior and powerful female executives on Wall Street. It is a shame to see her go because Wall Street needs more female representation in the C-suite. But someone’s head had to roll – and the head of the office that permitted this trade is the obvious candidate.

The CIO office at JP Morgan has made money over the last 3 years. They reported $5 billion in profits over that time span. So, even after the $2 billion loss, the office is still in the black.

But is being in the black enough? As a Buy & Hedge investor, we know the answer is no. Positive returns alone are not sufficient. The returns must be appealing on a RISK-ADJUSTED basis.

The actual risk that the CIO office at JP Morgan took to make $5 billion in profit is not readily available to us. However, the $2 billion loss it took on one trader’s 3-part trade is the ULTIMATE risk-adjustment to JP Morgan’s returns.

To allow one trader in one office to generate that kind of loss means that JP Morgan is risking a large amount of capital at any given time. Of course, JP Morgan will point to things like the net long or net short positions for the firm being very small in terms of billions of dollars. They will point to things like the Value at Risk measurement to point to a limited daily risk in their portfolio.

But clearly, to be able to lose $2 billion in only a few short weeks, the firm permitted a level of risk that was unacceptable. They have admitted as much though to admit otherwise would make them look foolish.

A report came out today that the trader in London that made these trades made a winning trade in 4th quarter of 2011 that made the firm $450 million in only 4 short months. The bet required at least 2 firms in a basket of 100 firms to have a detrimental credit event in the four months leading up to December 20th. That is a very focused bet over a short time frame. But it worked and the pay off was great. That clearly seemed like a lottery ticket kind of bet.

In the end, make sure you think about the amount of risk you take to make any amount of profit and make sure the two appear aligned. If you tell me you made 10% last year and are happy about it, I am going to ask you: “How much risk did you take to make that return?” Because, if you had to "roll a 7" five times in a row to make that return, I will tell you: “You didn’t make enough”.

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