How Does The 80/20 Rule Apply To Investing? 4
What does the Rule imply, and how does this affect the way we think of and trade the markets?
A common way of thinking about the 80/20 rule, especially in corporate/personal improvement settings, is as a means to increase productivity.
In truth, the 80/20 rule is more an expression of the lumpy nature of life. Change tends to happen in big, and very noticeable ways after a prolonged period of very little change.
Ernest Hemingway described this perfectly in his novel The Sun Also Rises:
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
From a broader standpoint, it means that the effects of a singular period of change dwarf the effects of the prior period of calm. This is also clearly expressed in the mainstream view of the 80/20 rule. If 20% of your time accounts for 80% of work done:
20% of time = 80% of work done
80% of time = 20% of work done
The effects of the 20% of time spent dwarfs those of the 80%, just like the effects of being bankrupt dwarf those of being not bankrupt, regardless of how long one spent being not bankrupt.
This is true for trading investing as well. As Kenneth Grant, in his book Trading Risk, describes:
For nearly every account in our sample, the top 10% of all transactions ranked by profitability accounted for 100% or more of the P/L for the account. In many cases, the 100% threshold was crossed at 5% or lower. Moreover, this pattern repeated itself consistently across trading styles, asset classes, instrument classes, and market conditions. (emphasis ours)
Obviously, market realities are a lot more extreme than normal life, pushing the 80/20 Rule into something more like 100/10 (it’s possible to be greater than 100 because other trades in the portfolio caused losses).
If you pause and think about it for a second, you would realize the sheer size of the profits on those 10% of trades (5% in many cases).
In the best case scenario, the other 90% of trades net to zero, and the 10% constitute all the profits of the account.
In the worst case, every single one of the 90% would be losses (but small on an individual basis, as the trader didn’t blow up), which means that the 10% of trades had to make up for the losses and push the trader’s PnL into the black.
What Kenneth Grant did not mention was that the Pareto effect occurs in the opposite direction too. Because of survivorship bias, only profitable traders were studied, but what about those who blew their trading accounts up?
The 100/10 observation will apply here as well.
Just as a small handful of trades can make a trader profitable (even hugely profitable) for a year, a small handful of trades can also make a trader blow up.
Even if a trader doesn’t lose more than 100% (because of leverage), any big loss will see them lose their job, which makes recovering from the loss impossible.
Put simply, 5 – 10 percent of trades make or break a trader’s year. Those same 5 – 10 percent of trades can also make or break a trader’s career!
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