What if one idea could improve every area of your life?
I’m talking about more money, a healthier body and better relationships.
Would you be interested in that?
Well, I’ve got it for you — the Pareto Principle.
The principle gets its name from an Italian economist, Vilfredo Pareto. Legend has it that he made a profound link between two unlikely subjects — wealth and pea pods.
You see, Pareto noticed that 80% of his peas came from 20% of his plants. This got him thinking about people’s wealth. He soon found that 20% of society owned 80% of the land.
And so the Pareto Principle was born: 80% of output is from only 20% of input.
While the ratio rarely comes to exactly 80:20, the imbalance is often striking.
Here are a few general examples:
- 20% of the workers do 80% of the work
- 20% of drinkers guzzle 80% of the alcohol
- 20% of your clothes get 80% of the use
- 20% of drivers cause 80% of the accidents
- 20% of customers do 80% of the spending
Just think about how the Pareto Principle affects you.
On a personal note, I enjoy a range of treats, like pizza and chocolate. But of the 21 main meals I eat each week, usually only four — or about 20% — are in the less healthy category.
My exercise routine follows a similar pattern. I typically go running five or six times per week. This averages out to being active about 80% of days.
The 80:20 mix helps me indulge while staying in shape.
The other thing to note is the Pareto Principle is fractal. This means you can break the process into smaller units by reapplying the 80:20 rule to a set of outcomes.
Take wealth for instance…
The Australian Bureau of Statistics (ABS) says the top 20% of households have a median net wealth of $1,285,600, while the median for the next 80% is $378,600 — a ratio of 68:32.
The top 20% has its own hierarchy. At the apex is the ultra-wealthy 0.4%, with a net wealth of more than $10 million. A notch below is the top 1.5% of households, with over $5 million.
Now, the ratios for this real-life example aren’t a precise 80:20 match. And it doesn’t matter. The point is that an oversize share of the output goes to a small portion of the inputs.
So how does the Pareto Principle apply to trading?
Let’s look at that now…
I’m going to start this section with an email from a long-standing member.
Have a read below:
‘If part of your thinking is that, on each entry, the potential profit/loss ratio should be 3:1, it follows that if the initial Stop Loss is 25% below the entry price, then the target should be 75% above that entry price.
‘There are currently 173 stocks in the portfolio. Of these, only 8 are now sitting on a profit of more than 75%. Clearly, these have the potential to make a very large profit.
‘With hindsight, however, is it not true to say that the probability of picking one of these signals to invest in would have been less than one in twenty (or 4.62%)?
‘What I’m wondering is, what would happen to the overall result if the system took the profit at 75% on the rare occasions that the target is achieved?’
Les raises two interesting points:
- Relatively few stocks are ahead by more than 75%, and
- Would a take profit strategy boost performance?
The portfolio currently has 166 open long trades (as of COB on 16 April). Of these, the top 20% of trades are showing an average gain of 82%, while the next 80% net-out near breakeven.
Here’s what this looks like on a graph:
Source: Port Phillip Publishing
Let me explain what’s happening…
The bottom axis ranks trades from best to worst, and the vertical axis shows the results. I’ve removed the top four trades (411%, 330%, 258% and 135%) to enhance the graph’s scale.
You’ll see a shaded area on the left of the chart. This contains the top 20% of all open trades. As per the Pareto Principal, these trades make up a big share of the gains.
Now, remember what I said about the fractal nature of the principle — you can break the process into smaller units by reapplying the 80:20 rule to a set of outcomes.
Do you see the shaded area within the shaded area?
This is the top 20% of the top 20%. These trades are up an average of 206%. Just like Australia’s spread of wealth, a relatively small group of stocks are well ahead of the rest.
It only takes one
Les says there’s only about a 5% chance of buying one of these super stocks.
And he’s generally right — only one in 15 signals are currently up by over 75%.
So is this a failing of the Quant Trader strategy?
Does a healthy portfolio require many big winners?
The answer on both counts is: no.
It’s not unusual for a few stocks to drive performance. According to S&P Dow Jones Indices, for the first half of 2017, over a quarter of the S&P 500s’ gains were due to just 1% of the stocks.
This is a key reason why I say you should spread your capital widely. By doing so, you increase the odds of buying some of the best performers.
A reason many traders fail is because they only have a few big bets. As Les notes, the odds of buying one of the top stocks with a single trade are relatively low.
I believe a better approach is to hold 20–30 stocks.
Sure, most of these won’t soar hundreds of percent.
And that’s OK.
Remember, the Pareto Principle is all about a few inputs creating most of the output. It may only take a single big win to produce a market beating result.
Next week I’ll answer the second part of Les’ email: Is it more profitable to sell a stock that reaches a 75% gain, or let it run until the exit stop is hit?
Getting this right could make you a lot more money.
Until next week,
Editor, Quant Trader
Editor’s note: The Pareto Principle isn’t just about stock returns. It could greatly impact your life in general. The key is to focus your energy on the activities that produce the greatest payoff.
All graphics produced by Quant Trader unless otherwise noted.
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