#### Applying the Pareto Principle (80/20 Rule) to Your Trading Strategy

Take a look at your trading performance. If you’re sitting on a net profit, what percentage of your trades are generating most of your wins? If you’re stuck with a net loss, what percentage of your trades are responsible for emptying your account?

If you discover that 80% of your outcomes, profits or losses, were generated by 20% of your trades (or something close to it), then you’ve just seen, with your own eyes, the Pareto Principle at work.

The Pareto Principle is all about “uneven distribution” of outcomes to causes. The standard theory says it’s 80/20, or that 80% of all outcomes come from 20% of all actions. It’s not always that clean, however. The point is that the small number of things you do can significantly affect the lion’s share of the results.

Sounds weird? Let’s take a deeper dive into this theory.

Pareto Discovers How the World’s Unevenly Distributed

Vilfredo Pareto was a 19th century Italian mathematician and economist. Aside from numbers, the guy loved to garden. One day he made a curious observation: 20% of the pea pods he planted yielded around 80% of his peas.

Sure, it was interesting, but it didn’t mean much until he noticed, at work, that around 80% of land in Italy was owned by only 20% of the population. After observing the same phenomenon in other countries (and in other fields as well), he wrote a paper on it and the Pareto Principle was born. Over a century later, it would be called the 80/20 Rule (same principle, but with a more modern-sounding moniker).

The World Seems a Bit Uneven

A few examples, some researched, others popularly believed:

• 20% of all students have grades that are 80% or higher
• 20% of workers are responsible for 80% of a company’s production
• 20% of all factories produce 80% of the pollution
• In 1989, a global study noted that 20% of the world’s population held over 80% of the world’s capital.
• Microsoft noted that 20% of the reported bugs caused 80% of the reported PC crashes.
• Video rental companies in the 1980s noted that 20% of their inventory generated 80% of their revenue.
• In poker, only 20% of the players walk away with 80% of the stakes.
• Last but not least, 80% of your profits may come from 20% of your trades OR 80% of your losses may come from 20% of your trades

As Pareto said, the world is unevenly distributed. So, how might this apply to finance and your trading?

Applying the Pareto Principle to Your Trading Strategy

The first step in applying the Pareto Principle is close observation. What areas reveal uneven distribution. Once you find it, do you keep it as is; in other words, is this a normal distribution to expect? Do you tweak what’s not working to improve it, eliminate it, or switch it out with something else? Do you put more emphasis, time, or capital into what’s working in your favor?

These are questions to ask yourself, and there’s no surefire answer as everyone’s trading approach, risk tolerance, and capital resources will differ. So, this is more an art than a science. It’s up to you to fine tune it.

Also, don’t get stuck in the numbers. You may not find a clear 80/20 distribution. You might find, instead, 70/30, or 90/10. The point is to identify the “uneven distribution,” and to determine what’s actionable and what should be left alone.

Diversifying Your Market Mix

Many money managers have noted that 80% of their profits come from only 20% of their holdings. This uneven distribution may have a lot to do with the economic environment. It also means that this distribution may be subject to change when the fundamental landscape changes. What was in the 80% may now be part of the 20%, and vice versa.

And unless your losses consistently exceed your profits, you may not want to rebalance your allocations.

Some traders prefer to “mix it up” with regard to their trading strategies or systems. For example, some traders will combine ultra-short term, swing trading, and long-term strategies to widen their potential “return sources.” This is called system diversification.

If 80% of your profits are coming from only 20% of your systems, then you’ll have to decide when the time’s right to tweak your underperforming systems or put more time and capital behind your outperforming systems.

Paring Down Your Indicators

Some traders subscribe to premium trading platforms that offer an incredibly large suite of tools and indicators. Yet, they use between 10% to 20% of all its features. What’s the point? The same can be said of indicators in general.

There’s a point at which adding more indicators will begin slowing you down. That’s because if you have enough indicators in the mix, some are bound to give contradictory readings. So, take some time to figure out which indicators may be working best for your trading approach. You may find that only 20% of your indicators give 80% of the most actionable readings.

There are numerous trend studies across multiple markets and time frames. Although the numbers may differ, what they do have in common is that trends occur far less frequently than do non-trending markets. If we were to average it out, then trends occur (you guessed it) 20% of the time, leaving the remaining 80% to trading ranges and consolidations.

So, how might you use this data? It depends. If you’re a trend trader, you need to prepare for the likelihood that 80% of the market may lead to whipsaws. You can develop a way to increase your upside on the 20% while reducing your downside risks for the 80%. You might even employ a small percentage of your trading capital (say, 20% or less?) to a secondary “mean reversion” strategy. Or you might just leave your strategy as is, especially if the profits exceed the losses.

Diversifying Your Total Capital

Some traders follow a “barbell” type strategy, putting 80% or more of their entire trading capital into the safest investments they can find while allocating no more than 20% of their capital to high risk investments or trading strategies.

If you think about it, your goal as a trader is to compound your trading profits. So, there’s no reason to bet your entire stake if it means blowing up your entire trading account. Something to think about.

The Bottom Line

The percentage of successful traders is probably smaller than 20% of the entire trading industry. Even then, the people who occupy the top percentile are probably shifting. At any rate, you want to belong to that successful minority. How do you do it? It’s easy to say “don’t think like the remaining 80%.” It’s much harder to do.

If you read Jack Schwager’s Market Wizards book series, or if you simply follow the top investors and hedge fund managers on mainstream media, you’ll notice that each trader has developed his or her own personalized approach to the markets. And their approaches are all very different. So, if you want to reach for that level of rare success, it’s time you begin developing your own way of seeing and trading the markets. Good luck!

Please be aware that the content of this blog is based upon the opinions and research of GFF Brokers and its staff and should not be treated as trade recommendations.  There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.