The risks of social trading

MoneyWeek readers tend to be traditional investors. They look at the fundamentals of a company, buy stocks or bonds and hold them for the long term. That's the right way to go about building your wealth. Do your research, pick quality assets, and reinvest the dividends. It's not exciting; and that's as it should be. But what if you want a little excitement and fancy dabbling in some racier things, such as forex, but you're perhaps a little nervous or unsure how to get started? In that case, you might be tempted by "social trading".

Social trading sites also known as copy trading or mirror trading offer novices the ability to carry out exactly the same trades as more experienced investors. They began in the forex markets in the early 2000s, originally for institutional investors to mirror successful strategies, but have become a growing (though still niche) market for retail investors. They are beguilingly simple. Sign up to one of the many online platforms, browse the list of successful traders, marvelling at their impressive returns, and pick one to copy. In some cases, you are then provided with signals from the traders also called "strategy providers" but executing the trades is then up to you. With other sites, trades are executed automatically by the system. But either way, in theory you can then sit back and watch the profits roll in.

However, the very simplicity of all this should ring alarm bells. Far from being a low-risk introduction to trading that removes the elements of fear and emotion from your own trading as some advocates claim copy trading simply exposes you to the fears and emotions of the traders you are following. Even if you do understand the ins and outs of the various underlying markets, you don't know the mindset of the person you're copying. You don't know why they're making the trades they're making.

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You also can't really judge from their records whether they are skilled traders. Anyone can have a successful run based on luck alone. It may last a week, it may last a year. But even the luckiest traders can see their fortunes blow up in spectacular fashion. Also be aware that on some platforms not all their reported positions may have been traded. Not all of their positions are closed out they may have some open positions that are deep in the red, which may not be recorded. Finally, bear in mind that these traders may not get all their income from successful trades. In some cases, so long as punters are following their trades, they will get paid whether their trades are making money or not.

Some social trading platforms are definitely better than others in terms of transparency and scrutiny of traders. However, no matter how well it's implemented, the entire concept of social trading has a major flaw. Yes, it's possible to make money trading, but you need to know what you're doing. Study the basics thoroughly, practise in a dummy account and form your own style of trading. If you don't know why something has gone wrong or right, you won't know what to avoid in the future. Blindly copying somebody else isn't going to give you the insights into your own personality that you need to be a successful trader. For that reason, it's best avoided.