Tuesday, July 29, 2014

Book Review #9: How I made $2 Million in the Stock Market: Author: Nicolas Darvas

After taking a long time (approximately two weeks) to read and then write a review of the books that I had reviewed previously, it is a happy feeling to complete reading a book and then finishing the review in a span of three days !!

'How I made $2 Million is a book for the traders. In this respect the tactics in this book are more relevant to the book 'Reminiscences of a stock operator' that I had reviewed previously. (There are significant differences between the two books. Mr.Livermore, the protagonist in 'Reminiscences' was an Operator [some of his actions may be considered illegal here in India] while Mr.Darvas is a Trader, a perfectly legal operation).

Nicolas Darvas is a professional dancer who came across Stock Market Investment by accident. For one of his dance performances, he was paid (well not exactly. The performance did not go thru and he purchased the shares) in the form of equity shares of a company which almost quadrupled in about a month.

The premise of this book is simple. Observe the trends in the stock prices, and trade when the price is at the lower end of a price band and keep owning the stock till the price is going up and maintain a strict trailing stop loss to limit your losses. The key decision is when to buy the stock. You don't want your stock price to fall immediately after you buy the stock. Mr.Darvas keeps a very tight trailing stop loss at the time of purchase and as the stock prices start moving upwards, he loosens the stop loss.

In his introduction to this book, Mr.Clem Chambers, comes out with a few concepts and points. He talks of 'Observer Bias', a tendency of the mind to highlight the profits while hiding the losses. Mr.Darvas was a medium term trader. Medium term trading is more profitable than short term trading. The strategy followed by Mr.Darvas was simple. Look for increase in trade volume. This indicates that something is afoot in this stock. Take a small position to validate your initial assumption. Buy more if your assumption is validated. Keep strict trailing stop loss and exit if your assumption is not validated. As the price goes up cover your profits by keeping strict trailing stop loss.

The last point in the above paragraph is a gem. Keeping strict trailing stop loss and selling out when the price goes adversely is the simplest tool available to remove emotions from your trading. As any expert will tell you, emotions are the enemy of wealth creation.

The book is divided into 10 chapters covering four section. In the section titled 'Gambler' covering Chapter 1, the author talks about his initial foray into the stock market. The section 'The Fundamentalist' covers Chapters 2 and 3 and section 'The Technician' covers Chapters 4 and 5. Last 5 Chapters (6-10) are covered in the section 'The Techno-fundamentalist'.

At the end of Chapter 10, the book ends abruptly. No epilogues or post-scripts.

While the overall idea covered in this book may be simple (buy low, sell high, keep stop loss, watch your purchase price), what makes this a good read are the innumerable life lessons that are sprinkled in at various pages of the book.

The book commences by describing author's initiation into stock market. As described earlier in this post, he came into Stock Investing entirely by chance when he was paid a remuneration for a dance performance in the form of stocks of company named BRILUND in which he tripled his investment in a span of a month. He became intrigued by the potential and started dabbling in Stock Market. Just like any amateur investor started investing in 'hot tips' and lost money. He randomly read finance magazines and invested in the tips mentioned in those magazines and lost money. He found that his purchasing the share was a clear signal for the market that the stock is due for a correction, a signal which the market acted on from the moment his purchase was formally registered in the books of the market. ('The sudden drops in prices immediately after he has invested his money are one of the most mystifying phenomena facing the amateur', says the author. Talk about an understatement !)

He decided that he was losing money only because he did not know how the market worked. So he methodically went about studying and learning how market works. From his gambler days, he moved to investing based on fundamentals. He decided that he will 'Trade' only fundamentally sound companies. He searched for those companies and bought them and sold at a loss. He followed the advice 'You don't go broke taking a profit' and sold winners at meagre profit. He followed the maxim 'Buy Cheap Sell Dear' (what could be more simple than that?) and tried 'Over the counter' stocks and lost money (he didn't know how OTC worked).

Based on the lessons learned, he came up with the following rules of investing.

1. I should not follow advisory services. They are not infallible
2. Brokers advice can be wrong.
3. Ignore Wall Street sayings how noble and ancient they are.
4. Do not trade OTC
5. Do not listen to rumours
6. Fundamental approach is better than gambling.

While following the fundamental approach, he often found that while the Industry moved in line with his fundamental analysis, the stocks did not. For example, he knew that Textiles will be going up, but the strong companies in the sector did not move up and a small company did. This puzzled the author.

Author felt so confident of his fundamental approach that he studied Steel Industry and identified a company called Jones & Laughlin. Everything was going for it. Strong Industry, Good rating, Good Dividend payout....But immediately after he invested, the share started falling. He sold off at a loss and his entire capital was about to be wiped off.

Having lost money by following a fundamental analysis, author then moved on to investing based on Technical Analysis. He decided to follow Price / Volume data and make his trades based on that analysis. He found that the stock price has a tendency to consolidate within a range. Once the consolidation is over, the stock can either move below the lower end of the band (sell signal) or move above the upper end of the band (buy signal). The author called this band a 'Box'. As long as the stock stayed within a band, you keep observing. Once it crossed the band you take action.

One criteria that he chose was to identify those companies whose price behaviour is normally inactive. Once those companies become active, that is the time to focus on them. Even when he followed this method, he found that he was making losses. That is when he discovered the power of 'Stop Loss'. Once he incorporated this into his buying habit, his performance improved.

Author uses a metaphor to distinguish an 'Inactive Stock'. When a normally tempestuous lady starts jumping and dancing normally pays any attention. But if a dignified matron were to do the same, eyebrows will be raised. Inactive stocks with sudden movement were like dignified matron.

One fascinating aspect of this book is the amount of time the author spends in analyzing his losses and learning the right lessons. At the end of his Technician phase the author summarized his Objectives and Tools at his disposal.

1. Right stock
2. Right timing
3. Small losses
4. Big profits

1. Price and volume
2. Box Theory
3. Automatic buy order when the stock touched a specific price
4. Trailing stop-loss

As he progresses in his trading behaviour, refined over the months based on lessons learned in the past, the author learned to separate his emotions from his action. He no longer felt proud when he made profits or felt sad when he made loss. In addition, he also learned that the stock do not move in isolation to the market. Based on his learning he started factoring in the overall market conditions before making any trades and this significantly improved his performance in the market.

The biggest lesson that he learned was that his method of using trailing stop loss was allowing him to get out of trend reversals much ahead of reversal cycle. While discussing this, author derides the habit of people to hold on to stocks even when they are falling. The trailing stop loss was helping him to remove emotions out of the 'Sell' decision.

In the remaining chapters, the author talks about his conversion from a pure Technician to a Techno-Fundamentalist. The market was going thru a correction, and he totally refused to trade in the market. He knew that market was a slave of earnings. He kept his eye open for Companies which have high earnings power 'In the Future'. Those stocks may not be cheap, but he will buy high and sell even higher.

Another lesson that he learned during this period was that the brokerage was low when he purchased higher quantities of stocks. Also, higher quantities of stocks could give you higher profits when the price goes up and cuts your losses (brokerage commission) when the prices go down.

Once the correction was over and market started reversing, the author's strategy began to work. He made huge profits in most of his investments. Where he made losses, they were minimal since he had covered the losses through stop loss mechanism. Soon his profits hit $500000. That is when he came to Wall Street and started trading from Broker's office. He soon found that he was falling pray to Wall Street Traders behaviour. He totally abandoned the method that got him so much of profit. He forgot stop loss, started buying on tips, started selling the winners early and keeping the losers.

And soon his entire profit was wiped out.

He realized that by trading in Wall Street, he had forgotten the method that made him rich by half a million. He realized that he has lost his capacity to 'See' patterns. He immediately took action. He left NY and moved to Paris with a strict instruction to his brokers not to call him at all and only send him the day end cables showing the price movement and the market movement. With this information, he started working at night when market was sleeping. While he was sleeping and the market was working, his agent, the Trailing Stop Loss, was working on his behalf to handle any market reversal.

Slowly his 'Touch' returned.

By remaining invested in a few companies like Universal Controls, Thiokol and Texas Instruments, Diners Club and other stock the author reached a market value of $2.02 Million somewhere in July 1959, almost six and half years after he transacted his first trade.

What are the lessons that I have learned after reading this book?

1. Use trailing stop loss. I have seen my holdings go up in prices significantly and then coming down and I have not been able to get any profit out of it. For example, I purchased IDFC at 50, it went up to 300 and then again came down to 70. I held on without selling. I could have exited at a profit if I had used Trailing Stop Loss. 'Small Loss, Big Profit' should always be my Mantra.

2. Do not love a stock. It is very easy to get attached to a stock if you buy it based on some assumption and the assumption works. For example, I purchased TISCO at 250 because its P/E was low and in about 6 months, the stock has more than doubled. Now, I feel that I and TISCO are 'partners' in my success. A stock is like Cyborg in the movie 'Terminator'. It may help you to make money, but it has no emotional attachment to you.

3. Buy when prices are going up. Not when they are going down. 'Averaging' is a strict no.

4. Do not hate a stock: You might have purchased it at the wrong price and made loss on that. That doesn't mean that I can't make profit out of that in future.

5. Do not look at rear view mirror when buying a stock: You would have seen that a stock doubling in three months. That doesn't mean that it is overpriced. Always try to look at the future potential of the stock. An example is my purchase of HDIL. I see that I had purchased it when it was 250, again when it came down to 120, again when it came down to 50 and it finally reversed when it touched 15. Currently it is trading at 85. That doesn't mean that it is overpriced. It only means that the price has moved up from 15 to 85.

The main message in his book can be summarized in a few sentences. Start buying when market starts to rebound, buy stocks of quality companies with future profit potential, regular review and keep Stop Loss. There are three main lessons that one can learn from this book. First one is about regular personal reflection. You have to analyses your losses and identify the behavioural patterns that led to those losses. Reflection is the path through which one can become a better person and a better investor. The second lesson is about continuous learning. Every time the author identified a flaw in his approach, he want back to the drawing board and read up and understood why that flaw happened and that helped him take corrective action. The third and the main lesson is that you don't have to be a professional in the market to make money in it, a point which Mr.Peter Lynch makes HERE and HERE

Both Mr.Livermore and author makes a very important point about the importance of timing the purchase of a stock. As per them, it is important that the price of the stock starts rising immediately after you buy the stock. While Mr.Livermore do not stress a lot on Stop Loss (after all, he is a Stock Operator), the author of this book is very particular that one should always maintain a Trailing Stop Loss for every stock that one owns.

One of the flaws (if you can call it such) of this method is that Mr.Darvas made money in the middle of a major bull market. It will be fascinating to see if this method will work in all kinds of markets. 


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