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Behind the Growth in "Expert" Advisors - Part Two |
by John Jagerson
Expert advisors and autotrading systems are certainly attractive ideas. The benefits to the broker seems obvious in the form of longer account lifespans and consistent trade flow but does the retail trader get what they expected?
The problem individuals face when trying to choose an expert advisors stems from the issue of survivorship bias. This is a problem in the mutual fund, newsletter and stock index businesses as well. Simply stated, survivorship bias hides the fact that most advisor's returns are probably due more to chance and timing than actual skill.
Check out the first article in this series to learn more about expert advisors.
It costs very little for an expert advisor to develop and begin promoting a system. In fact, most advisors will create many systems. Those that perform poorly are closed and those that perform well are promoted. Traders tend to focus on very short term results and will "chase" returns from one advisor to the other.
The danger in this is that traders don't understand that the system is a survivor of a much larger pool of others. If past results have a limited ability to predict future results then there are very low odds that the survivor will continue to perform in the future. Traders may not realize this because they are not aware of how large the pool of original systems was.
This is further compounded by the fact that in order to be noticed, a system designer or expert must show extraordinary returns. This usually means lots of leverage and a lot of trades. This may result in some short term runs that are very profitable but also increases the risk of significant losses. In the video I will share some specific examples of this problem with two popular expert advisors in the forex.
Hulbert Financial Digest (a newsletter rating company) did an interesting study on survivorship bias. They assumed that starting in 1980 a trader would put $10,000 into an account and follow the best performing expert from the previous year. The account would then be reassigned to follow the best performer in each subsequent year. Within a few years that account was worth less than a dollar.
The bottom line is that above average returns are attractive but they can hide serious dangers. Traders have a tendency to focus on winners and ignore failures. That leads them to attribute too much of an expert's short term success to skill rather than luck. Managers and experts that have very long term track records tend to look more "normal."
Next: How the Fed Works and Why it Matters to You
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