Showing posts with label rule of the pyramid. Show all posts
Showing posts with label rule of the pyramid. Show all posts

Sunday 3 May 2009

The Rule of the Pyramid

This is another simple concept one can incorporate into one's investing knowledge. For long term investors, this incorporates the other investing concept of tactical asset allocation.


The Inverted Pyramid

Playing the "Inverted Pyramid" describes the buying pattern of many players (usually "never-die-before" trader) chasing after a charging bull. An inverted pyramid is narrow at the base and gradually broadens at the top.

In a bull market, after several successful attempts, he became overwhelmed by how easy it was to make a quick buck from the market. He became more convinced and his greed manifested itself as the market trended higher and higher. His bets grew bigger and more aggressive than ever.

Building on such a foundation is senseless and perilous. Needless to say, the small winnings from the early stages are by no means sufficient to cushion even a minor correction of the market, not to mention a major deccline, when one has been exposed to huge quantities of highly-priced stock way in excess of one's risk appetite can bear. It is one of the most grievous and typical mistakes of a loser.



The Rule of the Pyramid



Assume that you are happily reaping profits from an upside rally or a huge bull run, gaining inn confidence and becoming undaunted by a possible correction or reversal in trend (the Bear).

Be always mindful of the Rule of the Pyramid. This is, as the market or stock price goes higher and higher, your bets should become smaller and smaller. In other words, the higher the market goes, the lesser you bet. Never risk more than 50% of your winnings back in the market again.

At the end of the day, after all the tiring mind games, guesswork, risk-taking and heart-stopping moments, don't you think you deserve at least something (be it small or big) as a reward for going through all that angst? Would you prefer to give it all back? Or even pay the market for what you had gone through?

This is a simple piece of common sense that not only prevents you from giving back all your winnings to the market after a rally, but also enables you to preserve your winnings.