Pareto’s Law for Successful Day Trading

While you may not have heard of Vilfredo Pareto, surely you must have heard of his 80/20 formula. Pareto was a Swiss-born Italian who studied income distribution in Europe during the late 1800s and early 1900s. He discovered that 80 percent of the wealth in Europe at that time was controlled by 20 percent of the populace. Moreover, his search indicated that this ratio—the 80/20—persisted in Europe over all of its history, and was equally true in the United States.

In fact, it’s just as true today as when Pareto first created the formula. More importantly, the rule is not only applicable to income distribution, but to a great variety of other things.

The rule was expressed thusly:  the difference between high performers (as he called them) and low performers was an amount equal to the square root of the total sample. The notion of 80/20 (or 20/80) was never mentioned in his writings.

But, in the 1940s, Dr. Joseph M. Juran, an industrial engineer and guru on quality management, termed this revelation “Pareto’s Principle” and hence the 20/80 Rule was born. While it may be misnamed, Pareto’s law can be a very effective tool to help you manage your trading effectively.

While we can argue about specific numbers, the formula bears out this truism:  a small number of items in most any sample will be responsible for a huge percentage of the total sample. Accordingly, 20 percent of the beer drinkers guzzle 80 percent of the beer sold in the U.S.; 20 percent of U.S. criminals commit 80 percent of the crimes; 20 percent of the stuff in your filing cabinet will account for 80 percent of the trips you make to retrieve something from that musty archive.

The point for traders surfing this Web site is that 20 percent of your trades will likely contribute 80 percent of your profits. And that’s a figure that you, as traders, ought to strive for.

In plain language, it means you ought to ride a winner and (quickly) sell a loser.

Why? Because the corollary to the Pareto Rule of day trading is that 80 percent of your losses will be caused by just 20 percent of your trades. Keep this principle in mind as you trade each day. Have full faith and confidence in your trades. Always cut losses short and let winners ride. Pareto’s Law can keep you on the straight, the narrow, and path to riches.