Price Headley's Daily TrendWatch
The 80/20 Rule Revisited
July 8, 2003
One of the most common e-mails we receive from traders is a request for help in
psychologically handling losing trades. These requests come worded in many ways, but
our answer typically is the same. In fact, or standard answer is a topic we've
discussed frequently in the Daily TrendWatch, called the Pareto Principle. You may
also know this principle under its more common name - the '80/20 rule'. For traders,
this simply means that 80% of your returns are produced by 20% of your total trades.
In any case, we'll be taking a look at the principle and how it applies to our
Multi-Cap Growth Portfolio. Hopefully, our explanation of the Pareto Principle using
a real-life example will solidify why it's an important rule to remember
Stock returns, like most data, can be distributed along a bell curve. Without getting
into a statistics lesson, this just means that you'll see very few really big winning
trades, a moderate number of good winners, and the majority of your stock trades will
be just mediocre. The same is true for your losing trades, but to illustrate our
point today, we'll just be looking at our winners. In the chart below, we've plotted
the number of winning trades against their corresponding percentage returns. Of the
fifty-three profitable closed trades since last October, the vast majority of them
returned less than fifteen percent. The most frequent result was less than a five
percent return! Check out the distribution graph of the winners below.
Multi-Cap Growth Portfolio: Average Number of Trades vs. % Return
So how is it that that the Multi-Cap Portfolio is up by twenty-two percent over the
last nine months? The Pareto Principle! We may not have had a multitude of huge
winners, but we had enough big winners and enough moderate winners to provide a nice
return on the portfolio.
So does the 80/20 rule apply in this case of this portfolio? Let's see. For this
calculation, we're not going to use open positions - just closed trades. As we
mentioned, we've had fifty-three winning trades, yet have had forty-two losing ones,
for a grand total of ninety-five closed transactions (obviously the winners were
bigger than the losers). Assuming that we began with a $100,000 account, the sum of
all of those closed transactions would give us a profit of $15,259.07, or an account
balance of $115,259.07. So, of the ninety-five closed trades, how much of that
$15,259.07 was produced by the top 20% of them, (or the top nineteen trades)? The top
20% of these trades produced $15,888.86 in profits - more than 100% of the total
return! In our case, it's not just the 80/20 rule; it's the 100/20 rule, where 100%
of our return came from just 20% of our trades. That's the power of the Pareto
Principle.
While our results were 100/20, we'd still recommend 80/20 as a benchmark, but the
numbers here aren't even the point. Our purpose today is to simply illustrate that
it's not reasonable to expect every trade to be a grand slam, nor do they need to be.
If you set your expectations accordingly, you'll avoid damage to your trading
confidence while still getting excellent returns.
Se não receio o erro é porque estou sempre pronto a corrigi-lo
There's no bull side and no bear side. JUST THE RIGHT SIDE!
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