Common Mistakes Made by New Investors

Hello folks,

Today’s topic of discussion is Common Mistakes Made by New Investors.

You might say hey Mandeep, I could have invested in Pfizer, Moderna, and J&J before the pandemic hit and made a ton of money on these stocks.

There are a few problems with this line of reasoning.

1. You’re comparing this to a placebo of cash sitting in your bank account, which is the wrong comparator.

The correct comparator is the alternative BEST option, which would be putting money into an S&P 500 index fund or similar (an active comparator). You will, in most cases, not beat the US stock market because most professional traders don’t outperform the US stock market. What’s the likelihood you will do this once or consistently?

To explore this further, let’s hypothetically say you invested $10,000 in Pfizer, and let’s pretend it grew to $15,000. You might think you made $5,000. But, wait! If a $10,000 investment into the S&P 500 grew to $16,000 during the same period, you have actually lost $1,000.

2. Who is sitting on the other side of the trade, and are markets inefficient?

When you buy something, someone else is selling it and vice versa; most trading today is done by the large financial institutions via computer algorithms. There is little human trading activity compared to 50 years ago. These financial institutions employ people that are PhDs in math and finance that get paid six to seven figure salaries. What you are saying when you buy an individual stock is you think it's undervalued. You are saying that it is priced incorrectly, markets are inefficient, and the person or computer sitting on the other side of the trade is wrong. You may not be stating this outright, but this is what buying an individual stock communicates.

Sure, markets are not perfectly efficient, but they are generally efficient or, rather, efficient enough that the question of efficiency has a near zero impact on possible actions you might consider taking. Even if markets aren’t perfectly efficient, do you believe that you are able to identify the source of inefficiency and exploit it continuously and consistently? Is that really a bet you’re willing to make? Even the financial professionals are ridiculously incorrect. Before you place a trade on an individual stock, it would be prudent to consider reading The Incredible Shrinking Alpha by Andrew L. Berkin and Larry E. Swedroe. This book dives deep into the evidence base of why you shouldn’t pick stocks. In the pharmacy world, we practice evidence-based medicine and prescribing that aligns with guidelines.

You wouldn’t just pick a random medicine off of your fast-mover shelf (like omeprazole) for a patient that has a prescription for lisinopril for hypertension and call it a day, right? The drug has to match the indication and have an evidence base of efficacy and safety in its pivotal FDA approval trials. Furthermore, prescribing has to align with patient characteristics and treatment algorithms in clinical practice guidelines.

Similarly, you shouldn’t just pick random stocks and hope that it all works out. It would be prudent to practice evidence-based financial decision-making. This means not investing in individual stocks.

If you are a stock trader, neither fundamental analysis nor technical analysis is evidence-based decision-making because they are in direct contradiction to the efficient-market hypothesis. The only difference between technical analysis and astrology is that astrology is better at predicting the future.

3. What if you’re wrong and lose money? What is the consequence associated with being wrong?

Lost money is forever gone and that means those dollars can never be invested in the total US stock market funds (VTSAX) or S&P 500 index funds. If you’re starting your career, you’ve lost out on decades that money could have been winning returns for you.

I’m going to steal an analogy from the shark himself, Mr. Wonderful. Think of each of your dollars as a soldier. Those soldiers died (you took a loss) because you didn’t send them to the S&P where they could have been bringing back prisoners for you at the rate of return of about 7-10% over long time horizons. Sure you can put new soldiers in the war, but the original soldiers are forever lost.

Warren Buffet said he got rich not from making smart investments but by making non-stupid decisions.

Specifically, he said, “Outstanding long-term results are produced primarily by avoiding dumb decisions, rather than by making brilliant ones.”

The question you really need to ask yourself is, “Am I willing to risk 7-10% returns in an effort to get a larger return on investment with a very high likelihood I will underperform 7% and actually do worse than the US stock market?” In the worst case scenario, you may have negative returns. If that’s a bet you’re willing to make, then you should consider making this play.

Personally, I’m not willing to bet I’ll end up with a royal flush when the opposition already has four of a kind. It’s just not a high percentage move. You might get lucky, but you likely will not. Why play a game you can’t win, when there is a game you can win - namely investing in low-cost, market cap-weighted index funds?

I am of the opinion that a new retail investor should first participate in index fund investing in 401(k)/403(b)/457(b), Roth IRA, and HSA. Trading individual stocks, call/put options, and cryptocurrencies should only be considered after these other steps have been taken. Furthermore, I would limit these other opportunities to a small segment of your portfolio, say 5% towards these riskier asset classes/derivatives.

Does this mean you shouldn’t buy individual stock? In most cases it would be suboptimal, but one notable exception is company stock purchased through employee stock purchase plan (ESPP). However, even when this strategy is used, I immediately sell shares after they are issued and diversify into something like ticker symbol VTI or VTSAX. The reason for participating in ESPP is not for the company stock, it’s for the guaranteed discount that you can lock-in by selling stocks immediately after issuance. The fact that its company stock is inconsequential.

All of this leads us to a question. How can you get all of the battle tested, tried and true knowledge as quickly as possible? I wrote a book explaining exactly this; it's short, it's cheap, and it's written in plain English. You can find this on the homepage or here.

This is currently sitting at 8 reviews with an average rating of 5 stars. I’d love to hear your thoughts regarding this book if you decide to give it a read. You could buy it on amazon, read it in two hours or slowly over the course of a week, and return it for a full refund. So you can basically get all of the information for free. No pressure either way. You won’t hurt my feelings.

Is there anything you found useful or that I missed above? If so, please leave a comment in the comment box below.

See you on the next one!

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Disclaimer: The article above is an opinion and is for informational/educational purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice. The author has taken care in writing this post but makes no expressed or implied warranty of any kind and assumes no responsibility for errors or omissions. No liability is assumed for incidental or consequential damages in connection with or arising out of the use of this information.