November 2, 2015

The 80 - 20 rule of stock markets

The Pareto principle states that, for many events, 80% of the effects come from 20% of the causes.

This rule applies to a lot of things in life. For eg., 80% of the wealth is owned by 20% people, 80% of your business comes from 20% of your clients or is generated by 20% of your employees and so on.

You can extrapolate this to stock markets and generally assume that 80% of your profits will come from 20% of your trades (metaphorically speaking).

For successful trading, you require 3 factors - a trading system, risk management and discipline (not necessarily in same order).

Risk management takes care of losses, discipline ensures you stick to your rules (choose some other occupation if you cannot do this) and trading system helps with appropriate entries and exits.

So when you take a trade, there are 4 possible outcomes each of which has a 25% probability of happening:

- small losses
- small profits
- big losses
- big profits

The first 2 cancel each other so what you are left with is big losses and big profits. Obviously, the only way you can make is by focusing on loss minimization. You need NOT worry about profit maximization because profits is whatever the markets give and you have no way of knowing how much profits a trade can generate. 

Cut losses fast and hold to winning positions as long as possible.

Do this on a regular basis and you will see how 80% of your profits will come from 20% of your trades.

If you cannot do this, you will be better off doing something else.

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