We are not sure who said it first, but it been oft repeated that the worst thing that can happen to a novice trader is to have some success with their initial trades. The question is why?
The most important skill a trader can acquire is the ability to take losses. Small losses, taken quickly are the hallmark of a great trader. This is by no means an easy skill to acquire. It therefore stands to reason that this skill will be all the more difficult to acquire if their first trades are winners.
Unfortunately our brains are hard-wired to undercut this process. Recent research (via Scientific American) on how our brains learn from positive and negative experiences shows that the brain experiences a surge of dopamine after a success and this helps improve neural processing. However the brain can get “thrown off by mistakes instead of learning from them.” From the article by Frederik Joelving:
The pleasurable feeling that comes with the successes is brought about by a surge in the neurotransmitter dopamine. By telling brain cells when they have struck gold, the chemical apparently signals them to keep doing whatever they did that led to success. As for failures, Miller says, we might do well to pay more attention to them, consciously encouraging our brain to learn a little more from failure than it would by default.
This task is by no means simple. Trying to emphasize the lessons from failure is a difficult task for many. As Brett Steenbarger writes:
At some level, many traders equate losing with being a loser. This frustrates them, depresses them, makes them anxious—in short, it interferes with their future decision-making, because their P & L is a blank check written against their self-esteem.
No wonder losses are hard to take. It stands to reason that novice traders that have experienced only winners are going to find it difficult when it comes time to take losses. Traders need to learn from mistakes, but our self-esteem is dependent on us forgetting mistakes as soon as possible.
Some analysts recommend that novice traders start out paper trading, in part, so they can get used to taking losses. We are in favor of paper trading to the extent that it helps traders learn the mechanics of trading (and taking losses). However there is no substitute for experiencing the ups and downs of actual dollars on the line (no matter how small an amount).
Fortunately for novice traders there is no better time to learn how to trade with actual risk capital. Electronic trading and rock-bottom commissions make trading small lots easier then ever before. Therefore novice traders can get their education underway doing actual trading (and taking actual losses).
Update: On a related topic FT Alphaville cites some research that shows why it is psychologically so difficult for investors to separate themselves from the herd.
