Here's the Worst Thing That Can Happen to a New Investor

When winning (short term) means losing (long term)

Photo by milos tomasevic on Unsplash

If you are a new investor, one of the worst things that can happen is successfully trading stocks and making money.

To some, that might sound nonsensical, and to people who read my book, you already know exactly why that is a true statement.

The key word in that phrase is trading.

You can get lucky trading stocks, and trick yourself into thinking it’s a good idea to continue trading stocks. But, just like 9 out of 10 professionally managed investment funds, your almost certainly not going to beat the average returns of the stock market.

(If you’re unsure why that is, read some of my past articles on investing or grab a copy of my book.)

If you trade stocks as a new investor and win big, odds are you are going to continue trading stocks even as you start losing money. This is something, I’ve always believed to be true but today, I will review some research that provides evidence to support this premise.

Learning the wrong lessons

The authors of a 2014 research paper called "Getting Better or Feeling Better?" wanted to see how retail investors change their behavior based on how good or bad their investments perform.

The paper’s focus is on people who are relatively new to the stock market, using data from Indian retail investors to understand how recent returns shape the way they build their portfolios and how often they trade stocks.

What makes this study unique is the massive dataset it uses, tracking over 100,000 individual investor accounts in India from 2002 to 2012. The authors studied things like the types of stocks people bought and sold, how diversified their portfolios were, and how frequently they traded.

The researchers looked at how past performance (both good and bad) impacted what people did next. They were especially interested in whether investors chased after certain types of stocks—like jumping on growth or high-performing stocks—and whether time in the market helped people make better decisions over the long term.

Learning the wrong lessons from a good outcome

When it comes to succeeding as a long-term investor, your focus should be entirely on your process of investing—think how aggressive your portfolio is, how diversified it is, and how often you buy and sell.

However, many people focus much more on short-term outcomes than processes and allow those outcomes to dictate their process.

The researchers found that when retail investors had a good run—meaning their portfolios performed well—they tended to take bigger risks afterward.

Rather than spreading their money across different types of stocks to reduce risk (diversifying), they often concentrated their investments into fewer stocks or specific styles, like large-cap or growth stocks.

The problem here is that this kind of behavior increases something called "idiosyncratic risk," or the chance that one bad investment could significantly hurt their overall returns. For example, if an investor outperforms the market by 100%, they might increase their portfolio's idiosyncratic risk by as much as 22% in the following quarter, which isn’t a smart long-term move.

Why? Because only a very small minority of people are able to beat the market in the long run. The longer you keep your portfolio concentrated on a handful of stocks, the higher your odds are of losing money.

Another interesting finding was that investors tended to sell off stocks that had performed well in the short run, likely due to something known as the "disposition effect"—this is when people sell their winners too soon and hold on to losing stocks for too long.

The disposition effect is one of the many reasons that just buying and sitting on an index fund is much more likely to lead to success in the stock market then picking individual stocks.

While investors may reduce their exposure to well-performing stocks in the short term, in the long run, they start to buy more of these types of stocks. This behavior is often called "style chasing," where investors flock to stocks that have done well in the past, expecting the trend to continue. However, this kind of behavior can be dangerous because past performance isn’t always a good predictor of future success.

Again, there are many reasons why picking stocks is a loser’s game.

One of the most surprising results was the role that time in the market plays. You might expect that the longer someone stays in the market, the better they get at managing their portfolio.

But, the study found that more experienced people don’t properly diversify their portfolios. Simply having more time in the market doesn’t automatically make you a more savvy investor unless you actively learn from your experiences and adjust your strategy.

This is something I wrote about last week; the evidence suggests that if you want to learn about investing, you are much better served cracking open a textbook or taking a class than ‘learning by doing.’

So, back to the original statement of this article: If a new investor trades stocks and wins early, this might be the worst thing that can happen, as it reinforces what is almost certainly a terrible investment strategy in the long run.

A better outcome would be they lose money on their first few trades and come to the realization that beating the market is pretty damn hard and just buy the whole market and call it a day.

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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.