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The Pareto Principle In Investing

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The Pareto principle also known as the 80/20 rule, states that, for many events, roughly 80% of the effects come from 20% of the causes. If we translate this principle to investing, it would mean that 80% of the profits come from only 20% of the trades we make in our portfolio. What this means is that most of the time, we will feel like our trades are not working and we are only making our brokers happy.

Whether we are profitable traders/investors really depends on how we embrace this Pareto principle. Those who are unwilling to accept this will always be looking for that perfect strategy that allows one to make money from almost every trade. Even when a profitable strategy is right before their eyes, they will be quick to dismiss it when they see that it doesn’t work in a very narrow, specific instance. This is the reason why we always read proclamations in the media that some strategy is no longer working.

On the other hand, those who accept that there is no exception to the Pareto principle will focus on making sure that they milk the 20% as much as they can while minimizing the damage from the other 80%. The trend following approach that I teach in the Quantitative Investing Course obeys the same 80/20 rule. Within the universe of Dow Jones Industrial Average stocks, trend following works well for some stocks, less well for some and downright fail for the rest. However, it doesn’t matter as it all works out in the end at the portfolio level. Let’s look at some specific stock examples of each case before we look at the portfolio level.

The Bad

Let’s start with the bad. This is an example of trend following having an indifferent result as compared to simply buying and holding the stock. Below is the stock chart of XOM going back to 2006 with trend following signals indicated by the green and red arrows. When the green arrows appear, we buy the stock. When the red arrows appear, we close the position.

Below is the comparison of the NAV chart between the trend following approach and the buy and hold approach for XOM.

$1 invested in 2006 becomes about $1.50 today using either approach. Clearly, all the trading in and out of XOM has been a waste of time.

The Ugly

If you think the example of XOM was bad, IBM would be the perfect example for the trend following skeptics to use to declare trend following dead.

$1 invested in 2006 would have become $0.90 today using the trend following approach whereas if you had just bought IBM from day one and held till today, $1 would have become about $2.50! Trend following not only cost you more in trading commissions but it also lost you money!

The Good

I purposely left this good example to the end because this is really where it makes all the difference. This is where the 20% contributes 80% to the overall performance.

$1 invested in 2006 turns into about $10 today using the trend following approach. We are looking at a 10-bagger here! On the other hand, the simple buy and hold approach only turned the $1 into about $2.80 today. This is still respectable but a far cry from $10.

The Good, The Bad & The Ugly

We can now look at the Pareto principle in action. Below is the NAV chart comparison between the trend following approach and the simple buy and hold approach at the portfolio level.

Using trend following, $1 invested in 2006 becomes about $6.90 today while the simple buy and hold approach would have turned $1 into about $6. Although trend following delivered more returns, the real improvement is in the maximum peak to trough drawdown the portfolio ever experienced during the Great Financial Crisis. It is really this defensive quality of trend following that makes it a good strategy to deploy during this late market cycle period if you do not want to miss out on further upside in this bull market and yet be able to sleep well at night.

If you’d like to find out more about trend following and how we invest to reduce risk to our portfolios (sleep is important), you can register for a seat here.

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