Imagine if you could increase the frequency of your most profitable trades, while minimizing the impact of your least. Well, this is precisely what an 80-20 trading strategy tries to achieve.
This article shows you different ways of applying the 80-20 rule to trading, ranging from stock selection, asset allocation, risk management, and diversification.
By the end, you will have a framework designed to help you find the best risk/reward opportunities in markets.
What is the 80-20 Rule?
The 80-20 rule, sometimes known as the Pareto principle, was developed in the early 20th century by Italian economist Vilfredo Pareto. It was first used in macroeconomics to characterize the income distribution in Italy, however its core idea has been applied to many different fields since then.
In short, the 80-20 rule states that 80% of effects are caused by 20% of causes. For example, it could be that 80% of a company’s profits come from 20% of its products. Or, 80% of a team’s results come from 20% of its players.
In reality, the numbers “80” and “20” are somewhat arbitrary. It doesn’t have to be the case that precisely 80% of effects cause precisely 20% of causes. The key takeaway is that, in many systems, a small number of factors have a disproportionate effect on the outcome.
How to Use the 80-20 Strategy in Stock Trading
Ok, now we understand the basic premise behind the 80-20 rule, how can we apply this to our own trading?
The truth is that there are many different ways to apply this concept to trading, but the main areas can be summarized as followed:
- Focus your attention on the small group of securities that generate the lion’s share of your profits
- Mitigate the factors that lead to the majority of your losing trades
- Spend less time focusing on the things that have minor impacts on your results, and more time on the things that have a large impact on your results
Essentially, by focusing on the most important factors that affect your trading results, you can simplify your trading process and make more efficient use of your time, energy, and resources.
80-20 Trading Strategy
The most obvious way of incorporating the 80-20 rule into a trading strategy, is to focus on the 20% of your portfolio that contributes to 80% of its success.
For example, we might look to only invest in the 20% of stocks that have generated 80% our trading profits, historically. Alternatively, we might choose to focus on the 20% of trades that led to our fastest profits, or the 20% of trades with the highest win rates.
What constitutes your interpretation of “success” is ultimately a personal decision, and will most likely depend on your trading strategy.
For example, day traders will probably be more interested in their fastest winning trades, while long-term investors will be more interested in their most profitable.
In summary, by spending more time analyzing our winning trades, we improve our chances of replicating their success, while also spending less time and effort focused on unproductive strategies.
Risk Management
In terms of risk management, the 80-20 principle suggests that a handful of positions contribute to the majority of your portfolio risk. Therefore, successful traders should seek to mitigate these.
The first step is identifying them.
For example, does the majority of your portfolio risk come from market risk, credit risk, political risk, or stock-specific risk?
Once you’ve found the 20% of factors that contribute to most of your risk, you need to monitor them closely and make adjustments to your portfolio in order to minimize their impact.
Asset Diversification
Asset diversification is a strategy in trading that involves spreading your investment across different kinds of assets, such as stocks, bonds, and commodities.
In other words, it helps to reduce risks by spreading your investments among multiple assets, so that if one underperforms the others can offset and compensate for it.
To achieve this diversification, we need to combine assets that are uncorrelated with each other. This way, our holdings are unlikely to suffer steep losses all at once.
Having said this, we also don’t want to over-diversify to the extent that it negates the returns of our main strategy. We want to be smart with our diversification strategy, not just do it for the sake of it.
With this in mind, we might use the 80-20 rule to invest just 20% of our portfolio in the most uncorrelated asset classes relative to the rest of our portfolio.
In doing so, we sufficiently hedge our main strategy without completely hindering its returns.
System Diversification
There are times when your trading system works and times when it doesn’t. In most cases, this is largely a function of the market environment.
For example, some trading strategies work better in range bound markets, some better in bull markets, and some better in bear markets.
Think about it like this. The 20% of strategies that contribute to 80% of your returns in a bull market, are unlikely to be the same 20% of strategies that generate 80% of your returns in a bear market.
This shouldn’t come as a surprise. If we’ve learnt anything about the 80-20 principle, it’s that cause and effect are unevenly distributed.
What it means is that we can’t just rely on 1 trading style to work at all times. A better approach would be to find a range of strategies that work best in different environments, and attempt to switch between them as and when we see fit.
By diversifying our trading systems like this, we can hopefully increase our trading performance across different market conditions.
Another observation worth bearing in mind, is that the market spends about 80% of its time whip-sawing and 20% of its time in a trend. This means that the majority of financial market gains happen in a relatively short space of time.
Therefore, to make sure you don’t miss out on these gains, you either need impeccable trading skills to time short-term market moves. Or, you need to be a long-term investor that’s always invested in the market.
Time Spent Trading
The 80-20 rule suggests that traders can spend a small amount of their time generating a large portion of their gains.
This is usually the result of being efficient with their time or capitalizing on high-profit opportunities that only appear briefly.
However, we also must maintain a balanced attitude and avoid becoming overly focused on short-term, high-profit possibilities at the expense of our overall portfolio.
Ultimately, the 80-20 principle is only a guideline, and trading success requires a well-rounded approach that takes a wide range of factors and market conditions into account.
80-20 Rule in Forex Trading
The 80-20 rule doesn’t just apply to stock trading. It also applies to Forex trading.
The concept is exactly the same, except the underlying instruments are currencies instead of equities.
For example, Forex traders can use the Pareto principle to:
- Only trade the 20% of currency pairs that generate 80% of their profits
- Set strict stop-losses (or outright avoid) the 20% of currency pairs that generate 80% of their risk
- Diversify their FX book with the 20% of currencies that are the most uncorrelated with the rest of their positions
Common Misconceptions About the 80-20 Rule
The 80-20 rule has certain misconceptions that may cause confusion.
Firstly, it is a broad guideline, not a firm law that guarantees success. Traders should always use their discretion when implementing any strategy.
Secondly, the exact ratio may vary. Instead of 80/20, it might be 70/30, or 60/40. The probabilities don’t even have to add up to 100 come to think of it. For example, 5% of inputs may be responsible for 60% of outputs. What I’m trying to say is that the Pareto principle is a hypothetical framework rather than an exact science.
Lastly, the 80-20 rule doesn’t imply we only focus on 20% of transactions and disregard the other 80%.
Summary
The 80-20 rule, or Pareto principle, suggests that cause and effect are unevenly distributed. In other words, the majority of results come from a minority of inputs.
This is a common phenomenon observed in many aspects of life – trading being 1 of them!
By identifying the inputs that have a disproportionate influence on our trading results, we can improve our returns, reduce our risk, and make more efficient use of our time and resources.