The 80/20 Rule of Trading | What the Pareto Principle Teaches Us In Terms of Outcome Expectations

 

This article on the 80/20 Rule of Trading is the opinion of Optimus Futures.

The 80/20 Rule of Trading

There’s this curious idea that’s gained traction over the last few decades across several fields and industries including finance. It goes something like this: roughly 80% of all outcomes come from 20% of all inputs combined.

What might this look like in regards to your trading success rate? A few examples:

  • 80% of your trading profits might be generated by only 20% of your trades, or…
  • 80% of your portfolio’s profits might be coming from only 20% of your positions, or…
  • Market trends constitute roughly 20% of an asset’s movement over time (according to this Investopedia article, it’s more like 25% on average).
This is just a small sample of numerous examples across many other fields and industries.

The 80/20 Rule – Coincidental Yet Consistent

If you’re not already familiar with this notion, it’s called the 80/20 Rule, or the Pareto Principle. To recap, it says that 80% of the effects (in our case, one’s trading success rate) come from 20% of the causes.

It’s a simple idea, but it can also come off as being somewhat “fuzzy,”  speculative, perhaps even pseudo-scientific. Yet it stands on solid statistical footing; coincidental, but consistent enough to be taken seriously. Theory aside, you can observe this phenomenon almost anywhere; and we’ll go over this in a short bit.

As a trader, 80/20 is an important rule to keep in mind, not only because a smaller portion of your trades might be generating most of your returns, but also because 80/20 is something you can observe across many aspects of your trading.

Before we switch to application mode, let’s first talk about this 80/20 principle and discuss its history and why it’s important. Afterwards, we’ll look at a few ways as to how you might apply it to your own trading.

ALSO LISTEN | Matt Z breaks down the 80-20 rule (Pareto Principle) and discusses how traders can prioritize what’s important so they can focus on the critical 20% of their trading that can potentially help produce 80% of their results.

Vilfredo Pareto Plants Peas in His Garden

Vilfredo Pareto was a late 19th-century Italian economist and mathematician. The discovery for which he was soon to be known happened not in the course of his work or research. It took place while he was tending to his garden…planting peas.

Among the pea pods he planted in total, Pareto noticed that a small fraction of his plants produced the majority of his peas. He took count and noticed that roughly 20% produced 80% of his crop. Not only was the distribution unequal, it happened consistently.

A curious observation, but no big discovery yet.

Then he noticed how 80% of Italy’s lands were owned by only 20% of the wealthiest people. Once he carried out surveys of similar land distribution in other countries, that’s when the proverbial light bulb went off. And hence the Pareto Principle was born (known today as the 80/20 Rule).

So what do garden-tending 19th-century economist-mathematicians do when they come across a groundbreaking idea? The first is probably a lot of wine, song, and other things, but history likely omitted those distractions to go straight to the “white paper” that followed.  After that, Pareto’s discovery, give or take a century, went “viral” (by pre-social media standards).

Here are a few variations that came afterward:

  • In 1989, a study of world GDP revealed that the richest 20% held 82.70% of the world’s capital.
  • Microsoft, at one point, noticed that fixing 20% of the most reported bugs resolved 80% of the crashes.
  • In the game of poker, 20% of the players tend to walk away with at least 80% of the stakes.
  • In sports, coaches noted that only 20% of the exercises impacted 80% of an athlete’s overall performance.
  • In the healthcare field, 80% of all injuries were attributable to 20% of the hazards.
  • In science, more than 80% of scientific breakthroughs come from fewer than 20% of scientists.
  • Video rental stores in the 1980’s and 1990’ noted that 80% of their revenue came from 20% of their product.
  • Crime statistics repeatedly show that about 20% of thieves make off with 80% of the loot.
  • Businesses have noted that 80% of their revenue comes from 20% of their customers.
  • Corporate psychologists have noted that 80% of your work productivity comes from 20% of your effort.
We can go on and on, but you get the point. So, how does this unequal distribution take place in the domain of trading? And how might you take advantage of it?

Applying the 80/20 Rule to Your Trading

Before we go further, just note that the Pareto Principle is, first and foremost, an observational principle. It’s about observing how you earn from trading, what you earn from trading, and what you can tweak in the process of carrying out a trading strategy.

Furthermore, the following ideas are merely suggestions to consider (don’t take it as advice).

Trends Occur Only 20% of the Time (give or take)

Strong market trends tend to occur slightly more than 20% of the time, leaving you stuck in a sideways market nearly 80% of the time. Knowing this (assuming you’re a trend trader), you’ll tweak your strategy and manage your risks to mitigate that 80%, capitalizing on the 20% trend period where (hopefully) you can generate more profits than losses from fewer trades.

System Diversification

The benefit of diversifying your trading system (systems with different market approaches) is that you can catch different opportunities when markets shift in favor of short-term, intermediate-term, and long-term approaches.

If 20% of your systems produce nearly 80% of your profits, then it’s time to potentially tweak the ones that aren’t working for you; possibly even spending more time or capital on the ones that do. Systems perform differently across time as market conditions change, so be sure to give yourself enough time to make a valid assessment of your systems’ performances.

ALSO READ | Is Your Futures Trading System Not Working? Find Out Why and How You Can Fix It.

Market Diversification

If 20% of your instruments are producing 80% of your profits, and if you’re using similar trading methodologies across all of the instruments you’re trading, then it’s telling you either

a) something about the state of the market (trending up, down, or non-trending),

b) something about the incompatibility of your approach to certain markets, or

c) that your approach is normal and may shift over time depending on the fundamental environment.

This is normal, and unless your losses are exceeding your profits over time, you may or may not want to tweak your instrument allocations.

Risk Diversification

Another important thing to think about when it comes to seeking growth and preserving your capital is to allocate only 20% of your capital to high-risk trading or investments. If you are truly confident that you can eventually grow your capital through trading, then why not keep 80% of it in an income-generating investment or a safe haven?

No responsible trader runs the risk of blowing up his or her entire capital stash.

Indicators

Hopefully, you’re not one of those traders who are using so many indicators at once that you consistently end up in analysis paralysis. Do take a look at the indicators you’re using and you may find that the ones most useful to you make up a smaller fraction of your total tools.

If around 80% of your success is attributable to only 20% of your actions (or in this case, your tools), then you might want to consider paring down to what’s working best for you.

The Top 20% of Successful Traders

Here’s something to think about. Take a wide-angle view of the professional trading field. Within it there are traders and investors who are known to have amassed huge fortunes trading futures. Not all of them started with a huge amount of capital. Not all started with top-of-the-line trading technologies.

Pay attention only to the top traders who’ve made money consistently. Jack Schwager’s Market Wizards series is a good place to start. Reflect on their approaches, their values, and how they’re doing things differently than most retail traders you know.

Check out our Interviews with Jack Schwager to learn more the habits, methods, and ways trading professionals evolve to become full-time traders.

This category may not be a clean 80/20 division, but it doesn’t really matter. The point is that the minority seize the majority of futures trading profits. And you want to be part of the minority.

The Bottom Line

When reflecting on the 80/20 Rule, don’t get stuck on the numbers. The main idea to keep in mind is “uneven distribution.” Just remember that 80% of your returns may come from only 20% of your trades. From a larger life perspective, 80% of your success may come from only 20% of your actions. It’s up to you to determine what they are and how to deal with the 20% and the 80%.

Disclaimer: There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.

Links to 3rd party sites are being provided as a convenience and for informational purposes only; they do not constitute an endorsement or an approval by Optimus Futures, LLC of any of the products, services, or opinions of the corporation, organization, or individual. Optimus Futures, LLC bears no responsibility for the accuracy, legality, or content of the external site or for that of subsequent links.

Notable Replies

  1. Great article! It’s useful to keep this principle in mind when evaluating your results. I see many traders measuring their success by the number of their winning and losing trades, and it is quite an inaccurate way of looking at it.

  2. Solid article. Being organized and ruthlessly honest with yourself by tracking your Excel or Google spreadsheets can be an effective way to test and implement this 80/20 principle. And knowing that managing risk and losses for the other 80% of your trades (or inputs) is of primary importance so that the 20% can potentially do the heavy lifting as far as outputs.

  3. Welcome to our community @FuturesOptionsPro Looking forward to your questions and feedback.

    Best,
    Matt Z
    Optimus Futures

Continue the discussion at community.optimusfutures.com

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