The Pareto Principle: 80/20 Rule

As a trend trader, it is likely that 20% of your trades will result in 80% of your profits so focus on riding winners and cutting losers. Learn to implement a proper position sizing methodology to your trading, ensuring that you can withstand a string of consecutive losses without going bust. A lot of people are going bust in many aspects of their lives because they are not focusing on the 20% that matters most. Forget the useless 80%, it’s bringing you down. Less is more, a popular aphorism coined by the famous architect , Ludwig Mies van der Rohe, is something I truly believe in.

It’s times like these when trend traders grow impatient and fail to cut losers and then impatiently take profits too soon (most likely shorts in early 2009). It doesn’t matter if you have multiple losing trades over the past several months as long as your overall risk on each trade is less than 2%. The Pareto Principle will even out your results in due time, assuming you have developed a known expectancy on your system and employ risk management (position sizing).

You may have an expectancy of 40% winning trades but I can almost guarantee that 80%-90% of your year-end profits come from 10%-20% of your successful trades. For example, you may have 4 winning trades out of every 10 but only 2 of those trades will supply you with at least 80% of your profits. The other two winners will be minimal or cancelled-out by commissions, slippage and taxes.

On the other hand, it’s probably likely that 90% of your losses will result from 10% of your trades because you ignored sell rules, threw good money after bad or had stops jumped. One or two in ten trades will be the culprit(s) for bringing on the most damage to your portfolio. The other losing trades will be minimal and cut quickly as you realize that they are not working out as expected.

So what is the Pareto Principle?
“The Pareto principle (also known as the 80-20 rule, the law of the vital few and the principle of factor sparsity) states that, for many events, roughly 80% of the effects come from 20% of the causes.

The original observation was in connection with income and wealth. Pareto noticed that 80% of Italy’s wealth was owned by 20% of the population. He then carried out surveys on a variety of other countries and found to his surprise that a similar distribution applied.

Because of the scale-invariant nature of the power law relationship, the relationship applies also to subsets of the income range. Even if we take the ten wealthiest individuals in the world, we see that the top three (Warren Buffett, Carlos Slim Helú, and Bill Gates) own as much as the next seven put together.

A chart that gave the inequality a very visible and comprehensible form, the so-called ‘champagne glass’ effect, was contained in the 1992 United Nations Development Program Report, which showed the distribution of global income to be very uneven, with the richest 20% of the world’s population controlling 82.7% of the world’s income.” – Wikipedia

Researchers find that the top 20 percent of people, natural forces, economic inputs, or any other causes we can measure typically lead to about 80 percent of results, outputs, or effects.

Here are some other illustrations:

  • In poker, 20 percent of the players will walk away with at least 80 percent of the stakes.
  • In retail, 20 percent of the sales staff will make more than 80 percent of the dollar value of sales.
  • Studies consistently show that 20 percent of customers lead to more than 80 percent of profits for any particular firm.
  • More than 80 percent of scientific breakthroughs come from fewer than 20 percent of scientists.
  • Crime statistics repeatedly show that about 20 percent of thieves make off with 80 percent of the loot.
  • In horse racing, 80% of races are won by just 20% of jockeys.

Note that 80/20 is simply shorthand for a very lopsided relationship between causes and results. The numbers don’t have to add up to 100. In some cases, 30 percent of causes may lead to 70 percent of results. Other examples may show a 70/20 relationship: 20 percent of causes lead to 70 percent of results. Or the split may be 80/10, or 90/10, or even 99/1.

Ride the winners and cut the losers and never be discouraged that more oftern than not, the majority of your trades will be losers and the great majority of your trades will be a wash (smaller winner or small loser). It’s the small minority of trades that will make you a consistent winner at the end of the year and over the course of a lifetime. Trend trading is boring and will probably give you a home run every one in ten trades with a couple doubles and triples in between.

Remember this – Stepcase Lifehack:

I’ve seen a few times where people try to create a diagram explaining the 80/20 rule with a pie chart. One fifth of the pie chart is labeled 20% and the rest is labeled 80%. While those of us with basic math skills can see how this adds up to 100%, the calculation undermines what the rule is about.

The 80/20 rule argues that 20% of the input creates 80% of the output. Inputs and outputs aren’t the same thing, and therefore can’t be made into the same pie chart. The 80/20 Rule could just as easily been called The 55/3 Rule, if 55% of the results were created by 3% of the inputs.

Don’t get caught up on the numbers. Both 80 and 20 are just examples of one type of uneven balances. The fact that they add up to 100 is a coincidence.

Be patient, you will be rewarded and don’t get caught up in the numbers but do understand the principle!

Does the 80/20 rule apply to your trading and life in general? How about your business or career?

Comments

  1. Funny thing – The 80/20 book above follows the principle. A good chunk of the book (say 70-80%) is repeat material or useless.

  2. gee, thought conservative diversification would give across the board gains over time: i.e. winners always shifting to different asset classes. thus allocation across classes, not specific investment within a class makes the most gains. think some nobel prize winner proved this one. otherwise the pareto principle(note: not the pareto optimality principle)means a rational investor should just go to vegas and try for the big payoff.

  3. Chris

    Great article and extremely important for traders to understand. It is the reality of the 80-20 law that motivates my discipline for money management and stop loss executions. I am about a 300 hitter but historically over 90% of my profits come from 15% to 20% of my trades. So I have to be ruthless in executing the stop loss transactions.

    I believe the power of this “law of the vital few” comes from understanding that it is a law of nature, like gravity or the ocean tides. It isn’t a rule that can be changed or ignored. It will effect you whether you are aware of it or not. The best approach as you point out is to manage your trading and your life to take advantage of it.

    Too bad we can’t have a stop loss rule to protect us from politicians. Your illustration that 80% of the loot is taken by 20% of the criminals suggests to me that 80% of the wasteful burden of government comes from 20% of the politicians. We need an automatic way to remove them from office. But its difficult to get agreement on an appropriate stop loss.

    Perhaps better “money management” would work. Just limit each government program to no more than 1% of GDP and the heat in the portfolio of government programs to no more then 10%.

  4. Chris,

    Longtime reader here. Are you just NOT trading this market ?

    best,

    jeff

  5. Jeff,

    I am trading in and out of DXO but other than that, just holding my Visa position. I am starting to collect data on stocks showing strength. The NH-NL ratio is showing some up-tick from the brutal beating it has taken recently. A positive shift will peak my interest. Not there yet.

Trackbacks

  1. [...] the reasoning behind it until  I discovered the 80:20 principle. Officially known as the Pareto Principle, the 80:20 principle states that roughly 80% of the effect is based on 20% of the cause. So for [...]

  2. [...] or 2 in 10 stock investments result in real profit. A common mistake in business and other applications of the 80-20 rule is getting caught up in the numbers and summation to 100% of the rule. Instead, take a step [...]

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