Created by an economist in the 19th century, the Pareto Principle has found its way into all different areas of life and is still used to this day. The basic idea is that for many systems, 80% of the effects come from 20% of the causes. In other words, a small number of factors have a large impact on the results.
This post will go into further depth on this principle and will also explain how this concept can be applied to trading in a number of ways, making for more efficient and effective use of your productivity, time, and energy.
What is the Pareto Principle?
This was developed during the 19th century by an Italian economist named Vilfredo Pareto. He noted during the course of his studies that 80% of the land in Italy belonged to about 20% of the population. The 80/20 ratio even became prevalent in his life, and he also noticed that around 20% of the pea pods in his garden yielded around 80% of the peas.
This has been found to be true in key aspects of life and is even famously known as the '80/20 rule'. Other examples of this are that 80% of a company's sales are produced by 20% of their products or services, and 80% of news coverage is based on 20% of world events, etc. So how can this idea be applied in the trading world?
80/20: The Pareto Principle In Trading
In trading, the Pareto Principle can be applied in several ways. There is a general understanding that in the markets, on average, around 80% of our profits come from around 20% of trades. Therefore, it is important to focus on making a small number of high-quality trades rather than a large number of low-quality trades. By doing this, you can achieve better results with less effort. It is very easy to get caught up in the day-to-day grind of monitoring the markets, placing trades, and managing positions. However, this can quickly consume more time than needed if you let it.
Using an effective trading method that is also very easy to understand and implement will give you the mental clarity and time to focus 80% on money management and discipline (we will get to these points later) while only needing about 20% of your mental energy for analysing the markets and finding trades. A lot of traders never even get to this point because they are constantly trying to figure out how to make sense of their trading system due to their current system being unnecessarily complicated.
Time Management
The 80/20 rule can also be applied to time management in trading. One way to do this as a trader is to spend the most time optimising the 20% of activities that generate 80% of your results. For example, if you spend a lot of time analysing data and know that it has a big impact on your results, you may want to focus on making sure that you spend enough time doing this activity. On the other hand, if you find that you spend a lot of time on activities that don’t have a big impact on your results, you may want to cut back on these activities and focus on the ones that do. To apply the 80/20 rule in this way, it can be helpful to track how you spend your time and the results that you achieve from each activity. This will allow you to identify which 20% of your activities are the most productive and focus your efforts on these activities.
By optimising your time management processes, you can use your time more effectively and free up more time to focus on the most important aspects of your trading, which will ultimately achieve better results. A popular misconception, especially among beginner traders, is that trading more and having high activity in the markets is good, which is in fact the opposite. Having high activity in the markets is not only potentially costly due to the transaction costs you need to pay your broker or exchange provider, but high activity in the markets can also cause the trader to overtrade, which leads to the trader taking many trade setups to the extent that he or she loses their market edge. That's due to the trader doing less research on each position and getting clouded judgement as a result of too much screen time.
While there is no exact number for how much time you should spend trading, the 80/20 rule can be a helpful guide. For example, if you want to cut back on your trading work-life balance, you may want to focus on only trading during the 20% of the day that is most active. This approach can help you effectively manage your time and focus your efforts on the most important part of the trading process. By only trading for a few hours each day, you can free up more time to focus on other aspects of your life.
Less is More, More is Less
Another way to apply the Pareto Principle to trading, for example, in Forex trading, is to focus on the 20% of currency pairs that generate 80% of the results. This means that you would only trade a few select currency pairs rather than trying to trade all of them. There are many forex pairs to choose from, and unfortunately, traders make the mistake of trying to trade too many pairs instead of choosing a handful of pairs at most to learn and really get familiar with those pairs as much as possible. Consistency in trading comes from consistent trial and error with the same few products over and over again, and this is very difficult to do if you decide to trade random pairs constantly. Another example of applying the 80/20 rule when choosing your assets is to focus on the 20% of assets that are most correlated with your trading strategy. For example, if you have a long-term trend-following strategy, you may want to focus on pairs that have a strong historical correlation with long-term trends.
The Pareto Principle is helpful for many traders who want to improve their trading performance. There are many other ways to apply it to trading. The important thing is to find the trading method that works best for you and your own trading style. Here are some simple examples of how you can use the Pareto Rule in trading:
Trending Markets Occur Roughly Only 20% of the Time
Strong market trends tend to occur slightly more than 20% of the time, leaving the markets moving sideways nearly 80% of the time. If you are a trend trader, it is very important to know and understand this, as you will adjust your strategy and manage your risks to mitigate that 80%, capitalising on the 20% trend period where (hopefully) you can generate more profits than losses from fewer trades. Knowing and understanding this will also help you not force trades that aren't there. One of the main reasons why traders (especially trend traders) lose money is that they lose patience and trade looking for a big move to happen while the market is just consolidating sideways and not doing anything.
80% Losses 20% Wins
That's right. What if I told you that you can be profitable by winning only 20% of your trades and going through times where you can experience at least five losing trades in a row? You are probably reading this, and when I say it is possible, you do not believe me (especially if you are new to trading), and I completely understand (don't worry, there will be proof of this). Another area where the 80/20 rule can be applied in trading is risk and money management. Unfortunately, not enough traders understand how important risk and money management are in trading and that you must have a strict and disciplined approach to them. Trading is not about just being right or wrong; it is about how much money you take from the market when you are right and how much money you give back to the market when you are wrong. As mentioned previously above, around 80% of our profits come from around 20% of trades, so when you really think about it, this should not sound so surprising to you. Still don't believe me? No worries! Let's see together that you can be right only 20% of the time and still make money.
As you can see above, there was still a 4.83% increase in account balance after only two trades were won out of ten. The art of trading is to run your profits and cut your losses, hence why the 80/20 rule works if you use it to your advantage.
80% Psychology 20% Trading Method
This is another example of the 80/20 principle. You should spend 80% of your time and energy on learning psychological control and capital management skills. For the remaining 20%, you can spend it on chart analysis and trading. If you trust and persevere with this, you will see significant changes in the way you trade. You will feel more comfortable, more confident, and safer, and ultimately see more consistency in your trading.
Many traders, unfortunately, never realise this. The reason is that they go all in trying to find a 'holy grail' strategy that will help them earn riches quickly and easily. And if the current method does not help them earn money, they will find another method, and the never-ending circle just keeps repeating until the trader quits for good.
The Pareto Principle is a powerful tool that can be used in many different areas of trading. Focus your energy and mind on the things that earn you money (the 20%, not the other 80%). It is great to work hard, but you must also work smart. What you need is a simple trading strategy and method. This is to eliminate the emotional effects as much as possible by not spending too much time in front of your screen. By applying the 80/20 rule to your trading skills, strategy, risk management, asset selection, and time management, you can drastically improve your trading performance and achieve better results.
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