Copy trading: An increasingly popular form of investing – is it worth the risk?

James Rowe: Copy trading is an emerging form of investing. But how risky is it, and should it form any part of your own portfolio? Let's find out on this episode of Which Money.

Hello, it's James Rowe in the Which? studio. And joining us this week, we've got Which? senior researcher, Megan Thomas. How are you?

Megan Thomas: I'm good, thank you. How are you?

James Rowe: Very good. I'm all good, thank you. And Simon Weidenholzer is a professor of economics at the University of Essex. Hello, how are you?

Simon Weidenholzer: All good. And you?

James Rowe: All good, thank you. Thanks both for joining us. Now, we're going to be talking about something called copy trading. We've never spoken about this on the podcast before, and to me, at the very least, it was a new subject for me. So forgive me if I sound like a novice. Megan, when did you first hear about copy trading? You sort of deal with investing quite a bit here at Which?. Is it a new one for you?

Megan Thomas: A bit, yeah. It's sort of on the fringe of some platforms, so it's not something you come across with most of the platforms we look at that are sort of established players. It's more of your sort of newer up-and-coming online-type things.

James Rowe: And a couple of those platforms people will have heard of, won't they? So eToro and Trading 212. We'll touch on them quite a bit more, I imagine, a little bit later on. But Simon, for you, I imagine you have known about copy trading for a lot longer than me and Megan have.

Simon Weidenholzer: Yes, yes. So we did some research quite some time ago, which I think started around 2017 or so, we started with that research project. But the premise of trying to copy somebody else's investment or follow somebody's investment strategies is not new. The New York Times, several years ago, they featured this story about Sylvia Bloom, who was a legal secretary. And she retired after, I think, 67 years at the law firm, so she had quite a stint there.

And when she retired and subsequently died, she left an inheritance of 8.2 million dollars to charity. And how she had managed to accumulate that wealth is that every time her boss had asked her to execute a trade on his behalf, she just copied that particular trade proportionally to her very, very modest secretary income. But over time, she managed – obviously over a long time, she managed to accumulate a quite substantial amount of money.

But that shows you somehow that this idea of copy trading or copying somebody else's investments is not new. It is just that copy trading platforms as such enable you to do that at the click of a button.

James Rowe: That's really surprising, isn't it? Because as Megan said, she said it's quite on the fringe of modern-day investing. But as you say, in a – not a professional capacity, but clearly it has been going on for a very long time, but definitely still on the fringes for a very long time.

Simon Weidenholzer: Yes, I would say so. So I think that copy trading platforms as such, they came up, I want to say, in the mid-2000s or so when you saw a lot of industries being transformed by similar ideas of using the internet, using platforms to interact with each other. And you'd seen, for instance, how Uber transformed the transportation industry, what an impact Airbnb had on tourism and so forth.

And so initially, I think it started out with just web-based trading platforms that allowed you at the click of a button to execute orders. And that was new at that time, it was not something that was available. And then over time, this has been augmented with social aspects, like on Facebook – a chat function, maybe you could have a public post, maybe you could have a following, maybe you could have a ranking of traders and so forth.

And then obviously, providing this kind of information, this kind of background allows you to replicate others' trades, just by doing what other people are doing. And later on, platforms enabled users to directly do that at the click of a button where you just – have your social trading platform and you observe others and you say, "Well, I see this person is doing these kind of trades, he's having such a return on his investment or her investment, and consequently, I want my 1,000 pounds to just follow each and every trade that person does."

James Rowe: Is it worth trying to differentiate between what I think – correct me if I'm wrong – what I would say is three different types of investing here? So one would be what I would call sort of normal investing, so just keeping up to date with the markets and sort of following what's happening. Then there's copy trading, which we've just talked about. And then there's also something called social trading. How do we differentiate the three from one another?

Megan Thomas: So social trading would be that you are looking at what maybe your peers are doing. It could be that you're looking on social media and someone's put their investment portfolio – say, "This is what I invested" – and then you've separately copied that. Whereas copy trading, you're getting a platform to execute that for you automatically. And as Simon said, every time they buy something, you automatically buy the same. So they might look very similar at first glance, but it's about whether you're making a decision saying, "I'm going to buy that," or whether it's just happening in the background.

James Rowe: And is now a good time to mention something called contracts for difference? Because I was reading the piece that you wrote for the Which? Money magazine. Money members will have had this land on their doorstep over the last week or so. What are contracts for difference? How does this play into all of this?

Megan Thomas: So contracts for difference are a complex type of financial instrument, essentially, that you can bet on the direction of the price of an asset. So instead – where you invest in something, you own underlying shares. With a CFD, a contract for difference, you're sort of speculating essentially on the movement of that asset, which means it's a lot riskier than if you were to invest in it because you don't necessarily own anything.

Simon Weidenholzer: Maybe for context, so contracts for differences are not entirely new. So there's the stories of the early days of trading when the ticker band came through. And there used to be then so-called boiler shops, secondary markets where you could bet, using this kind of information, on the direction of the movement. So they pre-date social trading and all that.

Megan Thomas: Yeah, but you can apply something called leverage, which magnifies both the profits and the losses that you could make on investment in CFDs, which is why they're at really high risk and not something to be taken on by beginners.

James Rowe: Because they are volatile, aren't they? They're banned in a lot of countries – the US – but legal in the UK. And the FCA estimates, what is it, 80% of customers lose money?

Megan Thomas: Yeah, there's a lot of warnings if you go into it. If you use one of these platforms, you'll see a little banner along the top that says what proportion of the users of that specific website lose money, and yeah, it's normally 70%, 80%. So yeah, it's not like your average investment.

James Rowe: Do you want to take us inside how all this works then? So I mentioned a couple of the companies before, so eToro and Trading 212. Probably well-known companies to a lot of people who are listening to us now. They've got quite aggressive advertising campaigns. I'm sure a lot of us have probably seen their adverts. So if somebody was to log into one of these accounts, how would it work?

Megan Thomas: So they're quite different. So on Trading 212, there's a section called "Pies". It's essentially like pie charts where there are different allocations – you know, it might be 25% off to this stock, 25% to that one – and there is a section within that that is social pies, which is users of the app have set them up and it can list as sort of the newest ones or the most popular ones. And you could go on and say, "Yeah, I want to replicate that." And that one is not copy trading, so that would be social trading because you have to make that decision if – you know, you might get a notification if that person invests in something new, and then you decide to do it, but it's not going to do it automatically.

James Rowe: You can tell why people might be confused because it might seem similar, it might seem exactly the same, but there's a slight difference there.

Megan Thomas: Yeah, yeah. I noticed a lot on Trading 212, a lot of pies themed around the US and Iran war, often using loads of different emojis like swords and explosions, it's not really appropriate. But they invest in different things like oil companies or arms companies that might benefit from the war.

Whereas on eToro, it's about the people. So there would be like, "This person is an investor," and they've done this well, "Do you want to copy them?" And that one, it would happen automatically when they make trades, you'd make the same ones. Another big difference would be on eToro, the traders, they could be investing in CFDs, whereas that won't happen with your pies on Trading 212.

James Rowe: Okay. I'm with you. I think I'm with you. But Simon, the idea here, and the way Megan's described it, is that it makes it seem incredibly easy for a beginner investor to log on and take part. Do you think that's the, first of all, the motivation of a platform like this, and also the draw for consumers, because it seems quite easy to get involved with, without people necessarily knowing how big the risks are?

Simon Weidenholzer: Yes, I think probably that's one of the draws. And also I think the fact that you can just copy other traders would, could potentially instil confidence in you doing that because they might serve as models in a certain way. And at the same time, it's fairly easy then to execute these orders. On traditional copy trading platforms, you can just say, "I want this amount of my money to exactly replicate what that person does." So you don't – it's literally just done at the click of a button, or a couple of buttons.

James Rowe: If you were to copy somebody, if there was a portfolio there and you wanted to copy, that could be anyone, couldn't it? The people aren't necessarily going to have certain qualifications. Some might, but a lot might not.

Simon Weidenholzer: So my understanding is that on some of these platforms, there is certain levels or tiers in terms of the – in terms of the experience or expertise that is required for people to be copied. Because being copied also brings benefits. Okay, so they – because otherwise why would you at all consider providing this kind of information?

So the way these platforms reward these experts or leaders, or however you call them, is by first reducing their trading fees. And second, they do have programs whereby they pay them a certain percentage of the assets under copy or following. If some of these traders have a substantial following, maybe – I think one of them was in the hundreds of millions – and then that person would be rewarded proportional to that following. So that shows you somehow that it does pay off if you're one of these superstar experts, so to speak.

James Rowe: Because they're earning commission, essentially. That's the bottom line.

Simon Weidenholzer: Yeah, so the way these platforms typically make their money is by the difference between the bid and the ask. So that spread, and that's what – how they finance themselves. So you don't have to pay a subscription or anything like that, they just get that spread difference. And then they kick back some of that to their experts.

Megan Thomas: And that does not necessarily – between these two platforms, that's much less of a thing on Trading 212. And I can't work out why people do put their pies up for copy because there doesn't seem to be any benefit. It's, I guess, just sort of like people want to feel like they're being copied, being seen.

James Rowe: It's more the social aspect, though, isn't it? It's reputation, I guess, for a lot of them, isn't it?

Megan Thomas: Yeah, yeah. Or it's like they think it's like funny, because some of these are just like jokes, which is true. But absolutely on eToro, yeah, there's the popular investors and the pro investors. The pro investors having a qualification, the popular investors just being copied a lot.

James Rowe/James Rowe: And you've done some research here at Which?, haven't you? Which I will ask you about in a moment. But given there is an academic sitting next to you, it would be wrong of me not to ask you about some academic research you've done. You said it, I didn't say that. But when was it? About six years or so ago, Simon, you did some – you did some research. Talk us through it, what were you doing? What were you looking at?

Simon Weidenholzer: All right. So that was together with colleagues, with José Apesteguia from Pompeu Fabra in Barcelona and Jörg Oechssler from Heidelberg. And so what we did is we brought subjects to the lab, and so asked them to participate in an investment game where we also paid out their earnings. And so what we did is we tried to have a stylised platform that offers some of these features that real-world trading platforms offer.

So in one setting, people were trading on their own. So they could choose among a set of given assets, which differed in their potential earnings and their risk profile. So, in the first treatment, they could trade on their own. In the second, we provided them with information on the success of previous traders. And in the third treatment, we allowed them to directly copy others if they chose to do so.

And so what we saw is that the mere provision of information on the success and strategies of others leads to a significant increase in risk-taking. And if you add the option to copy somebody else to the mix, it leads to an even larger effect. So that was what we found in that experiment.

And so the underlying idea is fairly simple. Success is very, very salient, okay? And so people might be inclined to copy others who've been successful. But the problem is that those who have been successful have also, more usually than not, taken on a fairly large amount of risk. Now, you see success, and at the same time, you don't see the failure. You don't see all those many people who have maybe followed a similar investment strategy, but at the same time, have not been lucky and went bust.

And so that is the main driving force. Another way to think about it is suppose there is two assets. Asset one, the safe asset, is you toss a coin, okay? And you get a payout of one pound regardless whether the toss lands. And the other asset would be, say, the risky asset, you get a payout of two if it lands heads and a payout of minus four if it lands tails. So in expectation, with the first one you get one, with the second one you get minus one.

Now, if you look at a group of people who are tossing these coins, say, 10 people are tossing the safe coin, you always see a one. But then you've got 10 people tossing the risky coin, five times you see the two, and five times you see the minus four. So five people lose four.

Now, the problem is if success is salient, so if you, maybe through rankings or only through information, observe the successful kind of type and you're more inclined to copy the successful behavior, you walk into this trap that you will copy the people with the risky strategy, which on top of that might even have a lower expected return, okay? So that is one of the downsides of it, is that success is very salient. You're inclined to copy successful people, but these have taken on a lot of risk, and so you might end up copying people who are taking on too much risk, and you might lose out from doing that.

James Rowe: Which is incredibly fascinating. You've managed to explain that really, really well. That sounds condescending to an academic, doesn't it? Of course it does. Of course it does. But I was reading through the research, and something under the heading of "Policy Implications" that was written, you suggested that the risk-taking might be even stronger in real-world copy trading situations. So is that to suggest that people are then more likely to take a risk with copy trading?

Simon Weidenholzer: No, I mean – so the point that we make in the paper is, okay, so we have this very stylised market, and subjects in the experiments more or less know what the states of the world are, everything is fairly – I wouldn't say obvious, but all the information on the market is available.

Now, in the real world, there's a lot of noise. You don't know what is going to happen. If you look at somebody and you see that person is trading in this and that kind of stock, it's very difficult for you to judge whether this is a risky strategy or that's not a risky strategy as a layman. Some of the platforms try actually to tease out a little bit on that side, there are tools of determining whether a strategy is risky or not, or you know, not perfectly, but you can so – for instance, if somebody has a lot of leverage positions, if somebody is not diversified, if somebody is just in one market, say doing currency swaps, then you know that person is probably on the risky side. But for the layman, that might not be transparent. So that's one of the issues is – when there's this fog of the financial system about, it might be even more enticing for you just to copy others because it's so complicated.

James Rowe: And again, the conclusion of the results, again, you called for more research into copy trading. Has that happened? Is that happening? Why were you calling for that?

Simon Weidenholzer: So we had a follow-up project where we tried to tease a little bit out why it is actually that people are copying others. And so we tried to pitch various motives against each other. One could be, do you really think that you want to gain from the expertise? Is it the case that you maybe just want to shift the blame? So in the sense that you want to have somebody around to blame if things don't work out your way. Or it could also be the case that you are trying to look for – just like a patient looking out for a doctor, just you're trying to find somebody who makes you more comfortable taking on risk.

And so we tried to pitch these motives against each other and we found that strangely enough, there is a large tendency of people to imitate or copy others, even in situations where they shouldn't. So people in that follow-up experiments, we asked them, "Do you want to imitate another person who will toss a coin for you, but you'll have to pay, or do you want to toss the coin yourself?" And about 40%, 50% of subjects said, "Yes, we're willing to leave money on the table just to have somebody toss the coin on our behalf," which speaks a little bit towards fairly irrational motives to copy others in that kind of experiment at least, and points towards the motivation for copying not being purely rational.

James Rowe: Well, from your research to Megan's research, talk to us about what you did, because you effectively wanted to put this to the test about how, again, how beginners approach this. What were you doing and how did it all work?

Megan Thomas: Yeah, so we worked with 10 beginners to investing. A couple of them had invested before, but they didn't know much about it, but most hadn't invested at all, ever. And we basically handed them these apps and just talked through how they went through it and what they thought about the idea of copy trading, because they hadn't heard of it.

And yeah, what we got was kind of, for the most part, exactly the same thing is that people don't trust themselves really to make these decisions, they didn't feel they had enough expertise, they just didn't want to take on any risk themselves. And they liked the idea. They were like, "Oh, great, I didn't know you could get someone else to – have someone else who's more experienced. I don't want to have to pick all these stocks."

And then, we found when we were asking people to choose who to copy, people were generally picking the most popular traders because both platforms we looked at ranked the people you could copy from most to least popular, well, I don't know if they go all the way to least popular. And with the biggest returns, which I think makes, you know, makes sense. You can see why they would think that.

James Rowe: Just to interrupt you there, and Simon, appreciate you're not a psychologist, but psychologically, you can understand why people would just choose somebody who seems to have a lot of people already copying them because it almost would feel like you're not the one taking the risk. It might feel like you're passing that risk onto somebody else to take. And, strength in numbers, there's a lot of other people putting their trust in somebody else, so psychologically, you could perhaps excuse people why they would go for the most copied person.

Simon Weidenholzer: Yeah, yeah, I mean, so that's definitely the case, that you might feel more secure in your choice of that particular expert, and for that reason, yeah, you're joining the crowd. But I think another thing that plays into this is a little bit the role of luck versus skill. Because some people on those platforms might mistake luck for skill.

And so there's a famous quote by the late Nobel Prize-winning economist Paul Samuelson, for instance, who said that those lucky money managers who happen in any period to beat the comprehensive averages in total return seem primarily to have been merely lucky. Being on the honor roll in 1974 does not make you appreciably more likely to be on the 1975 honor roll. So already back then, he basically observed that there is no correlation between previous success of money managers, experts, and future success. And I think, also in the empirical literature in economics and also finance, it's a recurring theme that money managers, net of the fees, at the very best return zero to their clients. So there is this belief somehow that most of what the success we observe is just random, is luck.  

Megan Thomas: Another thing we found as well was that people couldn't, like Simon said earlier, couldn't make sense necessarily of how much risk they were taking on, and they'd kind of look at perhaps, you know, it would show a portfolio and go, "Oh, I've heard of some of those companies, it's probably fine."

Or, in the case of eToro, they actually did provide a risk score, but this score was not the most helpful, necessarily. So, for example, it might say "3" in like a light green shade. And so people say, "Oh, great, that's really low risk." But that portfolio actually had like Bitcoin in it, just in a smaller percentage. And so when I asked people, they were like, "Okay, great, I'll pick this person." And I'd say, "Okay, would you be happy investing in Bitcoin?" "Absolutely not." But they just didn't – they kind of looked instinctively at a low number and like a green and were like, "Okay, great, low risk."

And then with Trading 212, it just kind of gives you an AI summary of the risk, so there is a lot of unknown. You just kind of jump in and trust.

James Rowe: Can you explain why as well? So in your piece, you wrote the fact that half of the people who were taking part in the research, half of them chose one of the most copied investors called Thomas Parry Jones. He's got 34,000 copiers currently. That's how many people are copying his trades. Can you explain why people aren't guaranteed to get the exact same returns as what he would, because it's not going to be exactly the same as what he's getting?

Megan Thomas: Yeah, so I mean, the first part is already what Simon explained about the past performance, it's kind of irrelevant. But also the returns that you see, you don't necessarily know what's going into them, so you might have to pay fees that he doesn't have to pay, you might have to pay taxes because they're from all over the world, these investors, you don't necessarily know they're paying the same. Because the trading, if you're investing, you might just buy into a fund or a stock and hold it for a long time and you don't have to pay any taxes when you sell, but if you're constantly selling and you're making these profits, you actually would have to pay taxes on them, and there's also the element of when he bought into that, whatever stocks he has, it might be that you've actually bought at a bad time and it's going to do much worse than how it's performing for him and he's got these amazing returns. I mean, yeah, when we took this screenshot in the magazine, it says he's got 155% return, but I did look earlier today and it's down to like mid-80s. So it's just like – it's just all about when – the timing, yeah. It's not what you'll see for yourself.

James Rowe: We haven't got long left, so I'm going to try and squeeze in a couple more questions. One on the FCA. Have you spoken to the FCA or what have they said about – about copy trading or about your research? What have they said overall?

Megan Thomas: So I did speak to the FCA. I think they kind of view copy trading as more of a fringe thing, and primarily concerning CFDs because that is where it was quite popular. And I don't think they consider it like a significant issue, and maybe don't see copy trading as something that people completely new to investing might encounter actually first, which I think is maybe more likely than we realise.

James Rowe: And what do you see, Simon, as the future for copy trading? Obviously, there's going to be a lot more people coming to investing over the next few years, especially as the cash ISA limit is going to be reduced for most of us down to 12,000 pounds. But for a lot of people, they might be drawn to invest money instead. What do you – what do you see is going to happen?

Simon Weidenholzer: I think, you know, I think that generally, I think more people will be drawn to – these online kind of trading platforms. I think that kind of market will will grow. In terms of copy trading, it's difficult to – to say what will happen, maybe a lot of it could depend on on how regulation progresses. But it could also be the case, you know, that it will continue to bloom. So it's up in the air.

James Rowe: No doubt you'll be keeping an eye on it, Megan.

Megan Thomas: Yeah.

James Rowe: Lovely stuff. We'll have you back in the studio again if anything does change over the coming months and years or so. But as I say, you wrote the piece originally for the Which? Money magazine, which Which? Money members will be able to read that in the latest issue. But Megan, for now, thanks very much.

Megan Thomas: Thank you.

James Rowe: And Simon, thank you.

Simon Weidenholzer: Thank you.

James Rowe: That brings to an end another podcast from Which?. There's loads more for you to read about everything we discussed today, just head to the episode description for more useful everyday advice. There you'll also find an exclusive offer for podcast listeners like you to become a Which? member for 50% off the usual price, giving you access to our product reviews, our app, one-to-one personalised buying advice and every issue of Which? magazine across the year. Plus, your membership helps us to make life simpler, fairer and safer for everyone.

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