Goodhart’s Law in Trading Systems

Today we will consider an adage known as Goodhart’s Law and its relationship to trading strategies. Goodhart’s Law is often stated as:
“When a measure becomes a target, it ceases to be a good measure.”
It was originally intended as a criticism of Thatcher’s economics, but Goodhart’s Law is everywhere.

I first came across Goodhart’s Law when I was working at a gold mine in the Papua New Guinea Highlands. Workers at the mine had been lax in recording safety incidents, so to prevent this, management introduced a prize for the team that reported the most safety violations. The outcome should’ve been obvious. Safety reports skyrocketed overnight, as every pothole, kitchen spill, or cluttered desk was diligently ticketed and reported to management. In an effort to reach a target, the workers gamed the system, and their hyperfixation on a specific measure made the whole system meaningless.

So, what does this have to do with trading? When developing strategies, traders, especially new traders, will often try to maximise specific measures while disregarding the consequences elsewhere. They game their own system, often with the naive belief they’ve stumbled upon some previously undiscovered trading holy grail.

The obvious target here is total profit or rate of return, achieved while disregarding all other metrics. Inexperienced traders might create a system, then optimise every parameter to maximise the return. They run a single test, and their system shows a consistent annual growth rate of over 100%. Incredible.

So, what’s the problem? Well, where to start?

The strategy likely comes with a massive drawdown. A hypothetical drawdown over 50% may be fine on paper, but an inexperienced trader is likely to quit before they even get close to this.
They have fallen victim to one of the many testing biases, such as sample bias, recency bias, survivorship bias, etc.
The trader may not have considered liquidity. When the trader takes their system live, they find they are unable to enter their positions, or worse, they are unable to exit a position that has turned against them.
They have based their strategy on short positions they cannot access. Not all stocks are available to short. Availability varies depending on the broker, and the list of stocks available to short can change daily.

It is likely the trader described above will not stick around for long; as predicted by Goodhart’s Law, they have gamed their system and themselves by focusing on a single measure, profit. The resulting system is unsustainable or inoperable.

If you’d like to learn more about developing robust trading strategies and avoiding common biases and pitfalls, sign up for our new Beginner’s Guide to Building Trading Systems.