“Follow the smart money” is one of the most oft-repeated phrases in finance. And there’s a lot to be said for learning from legendary investors like Benjamin Graham and Warren Buffett.
But some people take “follow the smart money” a bit too literally by mimicking everything a particular celebrity investor does — a practice known as copy trading.
Copy trading has spread like wildfire in this age of social media influencers. Nearly every financial website sports an ad for some kind of copy trading service.
As appealing as these services might sound, they’re hamstrung by a set of unavoidable problems that every investor should consider. Let’s take a look at them…
Pricing & Timing Issues
How do influential investors become influential?
This isn’t a trick question. They make winning trades by quietly buying low and then selling high.
The quietly part poses a problem for copy traders, as it effectively guarantees that they’ll buy in for a higher price than the investor they’re copying.
After all, once that investor has bought their own shares and started to alert their followers about the trade, they’ve already boosted the price — often substantially in the case of popular investors. And the longer a copy trader waits to execute a trade after a copied investor, the more of a premium they’ll pay.
Needless to say, this problem repeats itself in reverse when it comes time to sell an investment. A copied investor will dump their own shares first, then alert their followers, causing a wave of selling which is guaranteed to hurt some of their copy traders.
In other words, the basic methodology of copy trading ensures that some of the followers are left holding the bag in every transaction — and that the copied investor always gets the best prices and the highest returns.
Poor Risk Management & Lack of Diversification
If the pump-and-dumpish nature of copy trading doesn’t scare you off, consider what copy trading could do to your portfolio allocation.
A significant number of the most popular copied investors focus on a particular asset class or trading strategy, like foreign exchange (forex) trading, binary options trading, or penny stocks.
There’s nothing wrong with any of these investments, but putting a large chunk of money into a copy trading system that exclusively focuses on one of them could really mess up your risk management.
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After all, the sort of high-volatility assets popular among copy traders — like penny stocks, options, and currencies — can lose huge amounts of value in the event of a financial downturn.
Older investors, in particular, should be more conservative and should think carefully before putting a substantial chunk of their net worth into them.
A Better Alternative to Copy Trading
Copy trading can sound appealing out of context, but as we’ve discussed today, the inherent pricing, timing, and asset allocation issues with the practice almost guarantee that a copied investor does not actually have their followers’ best interests at heart.
However, many of the perverse incentives that plague copy trading go away if the influential investor isn’t buying and selling the investments in question themselves.
If you take your advice from an expert or researcher instead of someone who’s actually trading, you can take advantage of their wisdom and experience without worrying about them pumping and dumping trades or chasing high returns at the expense of overall portfolio design.
After all, a non-copy trading research service succeeds by making its subscribers happy, not by profiting from trades that have been artificially juiced by a network of followers.