The ‘golden mean’ of trading, and more...
If you are interested in stock trading and investment, you may have heard that only 20% of the market players could boast stable revenue streams. This fact is a typical manifestation of the Pareto principle. You can use this principle to optimize your trading, while simplifying the choice of strategy and instruments, increase profit – and generally make your trading more comfortable.
The world is ruled by... imbalance!
The Pareto principle, which applies to literally every area of human life, is traditionally stated as follows: 20% of the effort yields 80% of the results. Respectively, the remaining 20% of the results require – apparently, not in the most efficient way – 80% of the effort. This is just one example of the curious law in action, but the main idea of the Pareto principle is the constant imbalance with proportions close to 20/80.
The phenomenon is named after Italian economist Vilfredo Pareto, who discovered this proportion back in the late 19th century, while studying the economic situation in the country. He found that 20% of the farms in Italy generate 80% of the total revenue. After making this discovery, the scientist tested his rule with other sectors of the economy. He was finally persuaded when he saw that 80% of the peas in his garden came from 20% peapods.
However, the law did not find much practical use until mid-20th century, when economists and businessmen started using the 20-80 rule. For example, the Pareto principle is generally believed to be behind Japan’s economic breakthrough in the 1970s. Particularly, the Japanese managed to isolate the small number of factors that had the most impact on the competitiveness of their products – as you can guess, these factors made up 20% of the total number.
This principle has been successfully applied in marketing, social studies, psychology – you name it. However, the proportions aren’t always the classical 20/80. Results like 30/70 and 10/90 are also possible, and they do not count as a big deviation from the classical Pareto distribution.
Trade better, earn more
No wonder the Pareto principle fully applies to stock trading. We already know about uneven distribution of profits among the financial market players, but we can’t extract much practical benefit from here. But we can get much bigger profits from observing the statistics of professional traders, those who get 80% of the money with 20% of the transactions. The rest of the deals are closed with negligible profits or even at a loss.
The proportion may vary individually, but the overall situation is exactly as described. If you analyze your own trading history, you can clearly see inefficiency of certain approaches to the market. For example, when you get most of your profits from a few long-trending positions, while numerous attempts to ‘scalp’ the market or catch reversals end up with zero profits at best, it would be only logical to concentrate on long-term trading with larger timeframes.
Even if you follow one strategy at all times, you can still discover some smaller patterns. For example, you might notice that your deals are most profitable in the morning, while in the afternoon and in the evening you wish you never turned that trading terminal on – a typical situation with intraday traders. By the way, this is Pareto rule at its best again: professionals spend about 80% of their time waiting for the signal to enter the market.
Thus, the knowledge of the ‘global imbalance law’ may prove invaluable for your trading performance. Making Pareto principle work to your advantage while improving your trading habits may help keep the number of losing deals to a minimum, while concentrating on the most profitable ones. This gives you not just more profits, but more spare time!