What if everything your financial advisor told you about building positions was backwards?
Walk into any brokerage office today, and you'll hear the same tired advice echoed from cubicle to cubicle: "Buy more when the stock goes down—you're getting it at a discount!" This conventional wisdom of "averaging down" has become so entrenched in investment culture that questioning it feels almost heretical.
But here's the uncomfortable truth: this approach is precisely backwards. And two legendary investors—Jesse Livermore and Nicolas Darvas—proved it over a century ago.
The Harvard Business School Revelation
In 1960, a young William O'Neil sat in Harvard Business School's library, hungry for investment wisdom that actually worked. Among the dusty business texts, he discovered Jesse Livermore's "How to Trade in Stocks"—a book that would revolutionize his thinking about position sizing.
Livermore's core insight was deceptively simple yet profound: "Your objective in the market was not to be right, but to make big money when you were right."
This wasn't about ego or batting average. It was about mathematical reality. When you're right about a stock's direction, adding to your position as it moves in your favor amplifies your gains exponentially. When you're wrong, cutting losses quickly protects your capital for the next opportunity.
O'Neil immediately adopted what Livermore called "pyramiding"—adding smaller amounts to winning positions as they advanced 2-3% from the initial purchase. This technique allowed him to concentrate his buying power when he was demonstrably correct, rather than throwing good money after bad positions.
The Averaging Down Trap
Before we dive into why averaging up works, let's examine why averaging down fails so spectacularly.
Picture this scenario: You buy 100 shares of XYZ Corp at $50. The stock drops to $45, so you buy another 100 shares, lowering your average cost to $47.50. When it hits $40, you double down again, bringing your average to $43.75. You feel clever—you've "bought the dip" and improved your cost basis.
But here's what you've actually done: You've tripled your exposure to a demonstrably failing investment. You've allocated 75% of your capital to a stock that's down 20% and showing clear signs of weakness. If the stock continues falling—which failing stocks often do—your losses compound dramatically.
This is the equivalent of a retailer seeing yellow dresses collecting dust on the rack and ordering three times as many. No successful business operates this way. So why do intelligent investors?
Enter Nicolas Darvas: The Dancing Millionaire
While O'Neil was studying at Harvard, a Hungarian dancer named Nicolas Darvas was unknowingly conducting the greatest real-world experiment in position sizing ever documented. Between 1957 and 1959, Darvas turned $25,000 into over $2 million while touring the world as a professional dancer.
The remarkable aspect of Darvas's success wasn't just the returns—it was how he achieved them. Managing his portfolio entirely through telegrams from hotel rooms in Bangkok, Bombay, and Buenos Aires, Darvas couldn't get caught up in daily market noise or emotional decision-making. He was forced to rely on pure price action and disciplined position sizing.
Here's a actual cable Darvas sent from Phnompenh, Indochina:
"BUY 500 CENCO INSTRUMENTS 7¼ STOP 6⅛ / 200 LORILLARD 31¼ STOP 29⅝"
Notice what Darvas did: Every buy order included an automatic stop-loss. More importantly, when his positions moved in his favor, he would cable additional purchase orders—always in smaller sizes than his initial position.
When Lorillard began its spectacular rise, Darvas didn't just hold his original 200 shares. As the stock moved through his "boxes" (price ranges where the stock traded), he added 400 shares at $35 and $36.50, then another 400 shares at $38.625. Each addition was made only after the stock proved its strength by reaching new highs.
The Mathematical Advantage
The genius of averaging up becomes clear when you examine the mathematics. Let's compare two investors buying the same stock:
Investor A (Averaging Down):
- Buys 100 shares at $50
- Buys 100 shares at $45 (stock down 10%)
- Buys 100 shares at $40 (stock down 20%)
- Total: 300 shares, $40,500 invested, average cost $43.50
If the stock rebounds to $50, Investor A makes $1,950 profit (4.8% return).
Investor B (Averaging Up - Darvas Style):
- Buys 200 shares at $50
- Stock rises to $52 (up 4%) - buys 100 shares
- Stock rises to $55 (up 10%) - buys 100 shares
- Total: 400 shares, $21,200 invested, average cost $53
If the stock continues to $60, Investor B makes $2,800 profit (13.2% return).
But here's the crucial difference: Investor B only deployed this capital because the stock was proving itself correct. If the stock had failed at $50, Investor B would have sold quickly with a small loss, preserving capital for better opportunities.
The Darvas Box Strategy in Action
Darvas developed what he called his "Techno-Fundamentalist Theory"—a combination of fundamental analysis to select stocks and technical analysis to time purchases. His approach was remarkably similar to what would later become the CANSLIM method.
Here's how Darvas would build a position:
- Initial Purchase: Buy a small "pilot" position when a stock breaks out of a consolidation pattern
- Confirmation: If the stock holds above the breakout level for several days, add to the position
- Pyramiding: As the stock moves into higher "boxes" (price ranges), add smaller amounts
- Trailing Stops: Always maintain stop-losses that trail the advancing price
When Darvas spotted E.L. Bruce breaking out of a base pattern, he started with a small position. As the stock proved its strength by holding new highs and advancing into higher trading ranges, he methodically added to his position. That single stock generated nearly $300,000 in profits—equivalent to several million dollars today.
The Psychological Edge
Beyond the mathematical advantages, averaging up provides crucial psychological benefits that most investors overlook. When you add to winning positions, you're reinforcing positive behavior and building confidence in your system. Each addition validates your original analysis and strengthens your conviction.
Conversely, averaging down creates a destructive psychological cycle. Each additional purchase represents hope over evidence, emotion over logic. You become increasingly invested—both financially and emotionally—in proving your original decision correct, even as the market screams otherwise.
Darvas understood this intuitively. Operating from thousands of miles away, he couldn't afford emotional attachment to his positions. His cables were businesslike and systematic: buy on strength, sell on weakness, always with predetermined stops.
The Modern Application
Today's investors have advantages Darvas could only dream of—real-time quotes, sophisticated charting software, and instant execution. Yet most still fall into the averaging down trap that Darvas and Livermore avoided a century ago.
The lesson isn't that you should never buy a stock that's declined. It's that you should never add to a losing position simply because it's gotten cheaper. As Livermore observed, "There are no good or bad stocks, there are only rising and falling stocks."
When you find yourself tempted to average down, ask yourself: Would I buy this stock today if I didn't already own it? If the answer is no, you shouldn't be adding to your position.
Instead, follow the Darvas model: Start small, add on strength, and always know your exit point before you enter. Your objective isn't to be right—it's to make significant money when you are right.
The market rewards those who bet bigger on their winners and smaller on their losers. Jesse Livermore learned it, Nicolas Darvas proved it, and William O'Neil systematized it.
The question is: Will you embrace this contrarian wisdom, or continue following conventional advice that leads to conventional results?
Sometimes the most profound strategies are hiding in plain sight, waiting for those bold enough to think differently.