The pyramiding strategy

Many investors are familiar with the concept of "pyramiding," or "adding to winning positions." The strategy involves starting with a small position in an investment and increasing it as the position becomes profitable. Conversely, if the investment moves against expectations, the position should be closed. Jesse Livermore was one of the earliest advocates of this strategy, and many of his successful trades followed this method, as chronicled in his book, "Reminiscences of a Stock Operator." However, opinions vary. Some investors argue against this approach, suggesting that one should instead add to losing positions if the fundamentals are strong, often leading to a turnaround. The effectiveness of "pyramiding" hinges on your investment philosophy. There is no one-size-fits-all answer; it should align with your investment system.

Understanding success rate vs. payoff

Before diving into investment strategies, it's crucial to grasp two concepts: success rate and payoff.

• Success Rate: The probability that a stock will rise within a specific time frame.

• Payoff: The ratio of potential upside to downside in a stock's price.

Investors often need to balance these two, but focusing on one can help make more informed decisions.

Example of payoff-focused investment

Consider a company that has developed a unique product and sales system with minimal competition for the next two years. Based on your research, you estimate the stock could rise 3-5 times within this period. Even if the likelihood of success is moderate, the potential payoff makes it an attractive investment.

In this scenario, the focus is on the payoff, with the success rate being a secondary consideration. However, certain conditions must be met to ensure the payoff investment is viable.

Example of success rate-focused investment

Suppose you find a consumer goods company performing well but not yet reflected in investor expectations. The company's convertible bonds offer an additional layer of security, mitigating systemic risks. Here, the potential for a moderate payoff combined with a high probability of success makes it an attractive short-term investment.

When the market index is high, funds often seek opportunities in convertible bonds for their favorable success rates.

Pyramiding in different contexts

The "pyramiding" strategy is more applicable to payoff investments. For long-term payoff investments, gains can be added when fundamental milestones (success rate inflection points) are confirmed. In short-term payoff scenarios, positions can be increased upon breaking resistance levels, enhancing the success rate at that moment.

In contrast, success rate investments might benefit from adding to losing positions if the underlying investment logic remains unchanged, thereby improving the payoff. Understanding the interplay between success rate, payoff, and investment duration is crucial. This knowledge helps investors adopt strategies from investment masters that genuinely align with their own investment philosophy.