Have you ever noticed that most of the money in the world is held by a relatively small minority of people? Or, how about that most people tend to work in short spurts of intense productivity followed by larger periods where they are less productive? There’s an underlying principle that can be used to describe such occurrences, it’s known as the Pareto principle, or the ’80/20 Rule’.
Some of you might be familiar with the ‘80/20 Rule’, some of you might not be. For those of you who haven’t heard of it before or need a refresher, according to Wikipedia, “it is named after Italian economist Vilfredo Pareto, who observed in 1906 that 80% of the land in Italy was owned by 20% of the population; he developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas”
The 80/20 rule is popular in business studies, sales, economics and many other fields. However, today we are going to discuss how the 80/20 rule applies to trading and the significant positive impact the “80/20 mentality” can have on your trading performance.
How the 80/20 rule applies to your trading
Quick note: These are my personal observations over my 10+ years in the market. The 80/20 rule is not an ‘exact’ science, but it does give you a very effective way to make sense of many aspects of trading and how they all fit together. Also, all ‘80/20’ ratios discussed below should be thought of as “approximate” ratios, meaning they could actually be 75/25 or 90/10, etc.
As Yaro Starak points out on the 80/20 Rule and Why It Will Change Your Life:
“By the numbers it means that 80 percent of your outcomes come from 20 percent of your inputs. As Pareto demonstrated with his research this “rule” holds true, in a very rough sense, to an 80/20 ratio, however in many cases the ratio can be a lot higher – 99/1 may be closer to reality.”
I wanted to start off with the above quote by Yaro Starak because in trading, the 80/20 rule is more like 90/10 or sometimes even 99/1 as he says.
How often have you heard “90% of traders fail while only about 10% make consistent money”? Often, I am willing to bet. Whilst the exact ratio of traders who make money vs. those who lose money is obviously almost impossible to pinpoint, it probably is somewhere between 80/20 and 95/5. Have you ever thought to yourself “why is trading apparently so difficult that 80 or 90% of people fail at it?” I’m willing to bet you have, and here is my answer to this pervasive question:
Trading is the ultimate “less is more” profession, but it’s also extremely difficult for most people to come to grips with this fact by accepting the following:
◾80% of trading should be simple and almost effortless, 20% is more difficult
◾80% of profits come from 20% of trades
◾80% of the time the market is not worth trading, 20% it is
◾80% of the time you should not be in a trade, 20% you can be
◾80% of trades should be on the daily chart time frame, 20% can be other time frames
◾80% of trading success is a direct result of trading psychology and money management, 20% is from strategy / system
Let’s delve into each of the above points a little deeper and see how you can start applying them to your trading, and hopefully start improving it, significantly.
80% Simple, 20% Difficult
This one is easy. Most of what we do as traders is sit in front of our computers and look at prices going up or down or sideways. This is not by anyone’s standards “hard” to do. Hell, you can put a 5 year old in front of a chart and ask them which direction they think it will go next and they will probably get it right more often than not. The point is this; determining market direction and finding trades is not hard, people make it hard.
I also personally trade with price action…because it is simple (and effective). The trading strategy you use doesn’t need to involve complex computer algorithms, counting ‘waves’ or interpreting heaps of indicators. In fact, most traders get bogged down with trying every trading method under the sun until they either give up or figure out that they were simply over-complicating what should be a very simple process.
The difficult part of trading is controlling yourself via not over-trading, not risking too much per trade, not jumping back into the market on emotion after a big win or a loss, etc. In short, controlling your own behavior and mindset, as well as properly managing your money are the hardest parts of trading, and traders tend to spend less of their time & focus on these more difficult aspects of trading, probably about 20%, when they should be spending about 80% of their time on them.
80% of profits come from 20% of trades
I am strong proponent of “sniper trading” and waiting patiently for high-probability trade setups, rather than the high-frequency trading style that tends to put so many traders ‘out of business’, so to speak.