Copy-Trading: When Lemmings Storm the Trading Floor
Today it’s about a topic that is often sold as something like Stock Market 2.0:
Gladly shown in the haze of catchwords such as swarm intelligence, machine learning or robotics.
Cool and really trendy, right?
Quasi the further development of investing for private investors.
If you’ve been following me here on Homemade Finance a bit longer and you already know my philosophy, then you probably already suspect what I think about it:
As I come to this conclusion, I want to explain to you here now, because I really want to prevent you burn unnecessary money with this nonsense.
- Brief introduction to copy trading
- Problem # 1: Survivorship bias
- Issue # 2: Copy traders are trading actively and underperforming
- Problem # 3: Hindsight Bias
- Who profits from the copy-trading trend?
- How to cheat scammers with copy-trading investors
- Copy trading and martingales
- Conclusion: copy trading is expensive, underperformed and is a playground for scammers
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Brief introduction to copy trading
The logic behind copy-trading sounds really easy:
You compare a bunch of traders and their strategy, picking out the ones you think are the most successful and following them.
The consequences usually happen automatically. Say, through a copy trading platform, the actions of the traders you follow are translated 1: 1 into your personal account.
I’ve picked out one of the most popular traders in the German-speaking world.
Quite deliberately, I do not mention the name of the platform or the traders that you can follow there.
Because advertising for something that I think is not good enough for you, I certainly do not do here on Homemade Finance. Point.
So, here’s the list of the top 10 traders on the platform:
You might think that you are simply picking out a few successful strategists, following them, and making your own such formidable returns without much effort.
Simple logic or not?
Of course wrong.
Three problems in advance:
Problem # 1: Survivorship bias
There are certain cognitive deficiencies in our brain, and copy trading behaves in this context just as much as comparing actively managed funds.
Looking back, using a list of traders or funds to compare or evaluate is pretty pointless.
Well, let’s take another look at the top 10 list from just now.
If we calculate the average performance, then we would have made an average of 48.85% pa when investing in all 10 traders, which sounds great. Simply split your own capital into ten equal parts and distribute them evenly.
That should still guarantee reasonable average returns of a similar amount in the future, or not?
Well, not necessarily.
For one, it is crystal clear that nobody knows whether the top people in today’s copy trading will still lead the ranking tomorrow.
Boring, but true:
Past results are no guarantee for the future.
If I follow Trader 1 today and entrust my money to him, that does not mean his strategy will work so well in the next 12 months.
That goes without saying.
The problem is that this applies to the whole squad. All 10 traders can in principle be financially dead in the next 12 months.
But what does a newcomer to copy-trading see when he looks at the Top 10 list for the first time in a year?
10 new, successful and successful traders whose strategy happened to work especially well this year.
But not the Investor Armageddon of the past 12 months, the 10 Trader corpses and your lost money.
Just a freshly polished list of people who had a good run last year.
That means the average return you can count on is not 48.85% pa but less. Because there are often a few “rivets” that you can not see in the list today, but for someone who has already entered in the past, pull the cut down.
In other words, comparing traders to a list puts you at risk of systematically overestimating the average score.
By comparison, the average returns on the stock exchanges, over long periods of time and after deducting inflation and tax, are around 5% per annum .
So you can figure out how much rivet must be there to (risk-adjusted) our 48.85% so far down to pull.
Issue # 2: Copy traders are trading actively and underperforming
As for all market participants, the old adage also applies in copy trading:
Back and forth, pockets empty.
To the performance of copy-traders, there are, to my knowledge, not really detailed, scientific investigations. However, so far secured Findings for the stock market in general of course also apply here.
And there it looks for any active form of action in the long run just bad. In other words, yield less than the market as a whole because transaction costs create a noticeable headwind.
There is nothing to shake it because the laws of the stock market apply to all equally. Whether lonely fund manager high up in the glass tower or sociable lemming down here on the street.
Both will get their expected value in the long term and this is risk-adjusted the already mentioned above about 5% after taxes and inflation per year.
That alone is in my view actually a manslaughter argument against copy-trading, but we still continue.
Problem # 3: Hindsight Bias
Looking back, it is always easy to say:
Oh, I would have.
If the whole world had known 80 years ago what would become of little Warren Buffett somewhere out of nowhere in the US, everyone would have invested in the young man.
But guess what: That just this little boy would enter the long term above-ground returns (about 25% pa), no one could guess.
In retrospect, it would have been wise to invest a few dollars, but this information was not predictive.
On the internet, people regularly read about people who are annoyed at various occasions about not investing in anything, be it Warren Buffett, Apple or Bitcoin .
This mistake is called hindsight bias .
What does this have to do with copy trading?
Well, comparing the different top traders presented on the platforms does exactly the same thing:
One is forced to think “Oh, I should have”.
Of course this is intentional, because the operators know exactly how people are ticking.
As soon as we are confronted with a retrospectively, theoretically very positive situation, we automatically want to react quickly so that we can at least benefit from it in practice.
Such a behavior was certainly beneficial in the hunt in the Stone Age, but such behavior generates losses in the financial markets.
It lets people do irrational things and that’s what the operators want. It suits them well when we chase after the constantly changing top traders.
Should the stupid investor run bankrupt while trying to catch the currently best trader.
The main thing is, he pays his fees and transaction costs.
Who profits from the copy-trading trend?
There are a lot of proverbs that say that if you want to find out the cause of something, then you just have to follow the trail of money.
Let’s do it now:
Basically copy-trading needs a platform where traders and followers can interact.
This is usually provided by a broker or an intermediary.
I will not name any names here, but if I scour the Internet like that, then I find there mostly old Pappenheimer:
Forex brokers and binary options platforms!
A few exceptions, which for example work with certificates, confirm the rule here.
As you may know, I have eaten these betting shops, as their lifework is merely to lure inexperienced retail investors into investments that are on the one hand much too expensive and on the other hand provide no added value for society.
As a long-term investment, this inevitably ends in failure and will make 99.99% of all people who dare to end up worse off than before.
Incidentally, this is not just my personal opinion, but proven by scientific studies.
These brokers (who have almost nothing to do with a reputable broker you buy your ETF for) have only one goal:
Make you move your capital back and forth as much as possible. After all, every move makes good money.
Copy trading is primarily a marketing tool to give you even more “interesting” opportunities to gamble with your money.
It is therefore almost always such rather dubious brokers, who advertise the supposedly limitless financial possibilities (= bag of ash) of copy trading.
On the other hand, there are the traders who provide their strategies on the respective platforms for followers. The platforms, in turn, engage these active traders (not the passive followers, of course) in the commissions and fees they collect to motivate people to fill the platforms with some sort of follower strategy.
It is important to note that both brokers and the forerunner traders earn from the followers and thus have a common interest:
And as always, when there is a lot of money in the game, there are always a few cheaters.
How to cheat scammers with copy-trading investors
I will now show you a trick that will allow you to cash in on low-minded followers on copy-trading platforms.
The catch here: It is absolutely immoral and of course punishable.
Therefore, I urge you to stop doing that!
I’ll explain the possibilities to you only because I find it disgusting if any criminal candlesticks exploit other people like that.
And since the underlying “trick” in this context is still unknown to most people, I consider it my duty to explain it to you here openly.
There are a variety of strategies in the financial markets and looking back (again keyword Hindsight bias) will always find one that has hit the market seriously.
In return, there are of course strategies that have underperformed.
If you were to follow all the strategies of this world at the same time, then you would receive on average exactly the performance of the market (before transaction costs, mind you!).
Of course, since many market participants, and especially copy traders, are behaving erratically, for the reasons explained above, the best-performing traders will naturally top the list, and the one who happens to be more recent will be followed successful strategy.
As a result, rain for the lucky guy plenty of commissions and profit sharing.
Nice for him.
Next year maybe another trader with a different strategy is at the top of the list and then gets the blessing.
And so the year turns from year to year. The trader, whose strategy was by chance the superior, gets the most money from the followers.
Interestingly, you can systematically recreate this “success” so that every year you are one of the successful traders in the list:
You simply offer followers every strategy that exists!
On most copy-trading platforms, if at all, one sees only yes-no, whether the one who fights the strategy has invested his own money.
This now allows you to risk completely without your own money or drive a very large number of strategies with very little money, of course, under different user names.
Now if you drive as many strategies AND the exact counter strategies (buying in one strategy and selling in the counter strategy and vice versa), then the chances are that one of the very successful ones.
And completely without risk, because the profits and losses of the two related strategies cancel each other out completely.
It’s all about offering the bar in the bar graph above, which was the largest last year.
This strategy is then followed by the followers and in the automatic replica flushes the image of the commissions as a very real money in the account.
If the strategy is a failure, then our fake ear suffers practically no or only very small losses.
Because offering a strategy costs little or no use and any trading losses are offset by the trading profits of the counterstrategy.
The problem here is that in this situation, losses are limited for the cheater, but potential gains are very large.
This entices you to simply “offer” many strategies with as little effort and automation as possible, and those that do great things will overcompensate for the low losses in other strategies.
A more concrete example:
Trader 1 from our portal list from above has generated a return of 27.41% over the past year through its strategy.
If he has now also the exact counter strategy, ie for each purchase a sale and vice versa, offered under another name, then he has here -27.41% made and to his actual strategies the bottom line deserves nothing, but also lost nothing.
The profit of one strategy is the loss of the other.
So why the whole thing?
He did not gain or lose anything by trading himself, but in the meantime earns real commissions and profit sharing from the followers of the exceptionally successful strategy, whereas the exceptionally bad one in Nirvana’s ranking has vanished and no one cares any more.
That would easily be enough to theoretically finance some other probationary strategies and, among other things, offer user names, even if transaction costs are at stake.
Although I can not prove it, I argue that a significant part of copy trading goes back to this form of fraud.
The attentive Homemade Finance reader will probably realize that the principle that underlies the whole scam is very similar to the perfect crime: the stock market letter .
Copy trading and martingales
If I still have not persuaded you to keep your hands off copy trading, then I’d like to give you at least one last piece of advice on your way here.
If a trader with a performance that looks like an almost straight line with sawtooths crosses your path, then steer clear of the Holy Water like the devil!
What happens here is that after a loss someone increases or doubles their bet. At first glance, this may seem like a genius, because it avoids losses in the short term, but in the long run will definitely ruin mathematically.
Why and why do I explain you in detail in my article on marginal or progression systems .
One of my most important contributions here on Homemade Finance, if you ask me.
Conclusion: copy trading is expensive, underperformed and is a playground for scammers
Copy trading is nothing but a marketing gimmick to the broker.
That may sound like a bit harsh, but it’s fact.
In the worst case copy trading is a quick way to burn money and, at best, just a fancy new package for something well-tried that already exists:
The investment in securities.
And what is ideally to be done, we should all now hopefully be clear:
If you want to pay extra for an interesting packaging, please. But that is directly at the expense of your return.
And of course you should always try to avoid that.
Why pay for certificate fees, profit sharing, or similar for average and long-term market performance when you can get more return for less fees?
In fact, I do not advise you to deviate from your plan (saving a long-term ETF portfolio).
Not a millimeter.
Just stay on course and go your own way instead of chasing the other lemmings into the abyss.