Nicolas
Darvas was a professional dancer turned stock market speculator. He happened to
stumble upon investing when one of his employers opted to pay him in stock
instead of cash. As it turns out, Darvas could not make this particular show
but in a gesture of professionalism offered to buy the shares from the venue
owners. This decision ultimately changed the course of his life and led him to
write his well-known book “How I Made $2 Million in the Stock Market.”
Despite the trite
title, the experiences shared by Darvas are invaluable to an aspiring trader.
Moreover, William O’Neill of Investor’s Business Daily and Market Wizards fame
built his proprietary CANSLIM process mirroring most of the Darvas principles.
While still effective
and useful today, the principles conveyed in this book are well-known and
shared openly online. Instead of touching on those aspects of the book, it will
be valuable to examine the emotions experienced by Darvas in his trading
journey. In particular, Darvas frequently exhibited classic heuristics that can
be explained by Behavioral Finance.
Behavioral
Finance is a blend of finance, economics, decision-making, game theory, and
psychology that you can use to your advantage as a trader.
Loss
Aversion
Several
times throughout the book, Darvas displayed loss aversion, or the tendency for
investors to take winners too quickly and hold onto losers too long. For instance,
Darvas writes that “I was buoyed up and excited by small gains, and overlooked
my losses. I completely ignored the fact that I was holding a lot of stock
which was standing well below the price I had paid for it and looked like it
was staying there.”
Additionally,
when Darvas was developing his Box Theory he noted that he needed to
“discipline himself to not sell a rising stock too quickly.” In order to lock
in part of his gain on a rising stock and combat this habit of selling a winner
too soon, Darvas would use a trailing stop that moved in proportion to his position.
Endowment
Effect
Darvas
displayed classic signs of the Endowment Effect. For example, he states that
“With no money involved I could easily control my feelings, but as soon as I
put dollars into a stock my emotions came floating quickly up to the surface.”
Simply put, the Endowment Effect asserts that when we own or create something
we will value it more than objective observers.
Familiarity
Bias
The
Familiarity Bias was exhibited by Darvas in that he favored the familiar over
new stocks at times. For example, he writes the following about Lorillard which
he had traded multiple times over the course of time covered in the book. “I
suppose I had a sentimental attachment toward it (Lorillard) because it has
done so well for me the first time.”
Moreover,
Darvas mentioned that after he began to make his first profits in some stocks
“this led me to prefer these stocks more than others, and before I knew what I
was doing had started to keep ‘pets’. I thought of them as something belonging
to me, like members of my family. I praised their virtues day and night. I
talked about them as one talks about his children.”
This sort of
disillusioned hope in the future of the stocks Darvas owned only stopped once
they started to create some of his largest losses and inflict emotional pain on
him. This outcome resulted from having his beliefs cloud what should have been
an objective assessment of price action.
Overconfidence
Bias
Darvas talks
about a period when he lost $100,000 over a few short weeks. He was out of sync
with the market after he moved closer to Wall Street and listened to his
broker’s advice more often. This close proximity created a false sense of assurance
that eventually led to his overconfidence. He states “Now I know that my poor
results were caused by egotism leading to vanity leading to overconfidence,
which in turn led to disaster.”
Overconfidence
bias will create an appearance of skill and mastery that does not exist. As a
result, a trader will take on more and larger risks when there is no edge.
Managing
your emotions and psychology are a key component in your trader development
journey. The more aware you are of your biases the better equipped you will be
to minimize their effect on your trading.
As always,
please feel free to contact me with any comments or questions. Thanks for
reading.
John
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