Articles for traiders
03/12/2019 07:12:15 pm

What is the Pareto principle and how to apply it to the Forex market

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What is the Pareto principle and how to apply it to the Forex market

Pareto principle is one of the most important discoveries for the financial sector. The principle is based on the so called "80/20 rule": 20% of the effort brings 80% of the result and 80% of the effort brings only 20% of the result. Pareto principle is used to assess the effectiveness of a particular activity. If you use it in practice, it becomes clear which resources provide the best result, and which bring virtually no return. It is this principle that brought rich people much of their success.

Pareto principle and how to apply it to the Forex market

Nature follows certain laws and each of its elements is forced to fulfill its role in a strictly deterministic system. However, it is precisely understanding of the structure of the world and its rules that gives certain advantages. The main feature of these rules - they work almost without exception. Accordingly, if you follow these rules, you are guaranteed to get the result at least close to the expected. One of these important fundamental laws is the Pareto principle.

Pareto principle, also known as the ”80/20 rule", states that 20% of the effort produces 80% of the result, and 80% of the effort produces only 20% of the result. The principle allows for an assessment of what resources and how should be used to ensure the best performance. This principle is used by well-known rich and successful people...

The discovery of Pareto principle

The first mention of the Pareto principle dates back to the XIX century, when the economist Vilfredo Pareto researched wealth distribution in Italy. During the study, scientist paid attention to a strange pattern: 80% of the wealth of Italy belonged to only 20% of the population while 80% of the italians owned 20%. To confirm the authenticity of his own observations, Pareto continued his research and made two important discoveries:

  1. This rule is true for other nations as well as for other centuries. The figures may differ slightly, but there is always a clear correlation.
  2. This ratio is a constant. For example, if 20% owns 80% of resources, 10% will own 65%, etc.

Pareto continued to develop the idea and put forward theories based on the redistribution of resources. At first, Pareto's theory was not widely used.

The theory became famous later, when the American Professor from Harvard University, George K. Zipf discovered in 1949 that the production system is self-organized to optimize labor costs and the end result. The data coincided with those indicated by Pareto. The same principle was confirmed by another scientist - Joseph Moses Juran, who realized that thanks to this law it is possible to reduce the number of defective products. Juran was the first to hypothesize that the 80/20 rule could be applied to any field of activity.

Applicability of the rule in the real sector

Pareto rule

Conclusions from the rule are obvious: a small amount of well-placed effort allows you to achieve great results. Therefore the bulk of the effort is marginal and wasteful.

Unfortunately, in accordance with the Pareto principle, it is almost impossible to achieve one hundred percent efficiency, because it will take a lot of effort, which contradicts the law itself. There is entropy in nature. Thus, there will always be losses and you should not chase the ideal result.

Another conclusion that can be drawn - it is better to spend a little time to choose the right strategy than blindly go through all the possible options, expecting that luck will turn to you the right place and the company will “take off”. People rarely think about how much effort they spend in vain, without getting the desired impact. For example, in a situation where a person is stuck in a hopeless position, giving up a favorite thing to which he has a talent because of the fear of failure. Or he gave up on a successful project only because of a single mistake. The list of examples can go on and on.

Following the Pareto principle in everyday life, a person can achieve high results in almost any field: relationships, finances, self-development, sports, etc. If you apply the 80/20 rule in time management, the main interfering factors are cut off. There are only actions that do not require much effort, but at the same time bring excellent results.

Law 20/80

Pareto principle perfectly demonstrates its effectiveness in business. The first company that successfully applied the principle was IBM. Employees noticed that in 80% of the time computers perform only 20% of the tasks. The remaining machines perform 80% of the tasks, spending 20% of the processing time. This allowed them to create a more high-performance computers, which were superior to competitors in the market.

Owners of car dealers are well aware that a rich buyer is more willing to buy a premium car if there are cheaper cars nearby. Approximately 80% of people will prefer to save money by buying a cheaper car while 20% prefer quality. It is these customers that bring about 80% of the profits to the business. 20% of the profit falls on 80% of people who prefer cheaper products.

How the 80/20 rule works in the financial markets

With regard to traders and investors, there are statistics, which states the following:

  • Only 20% of traders make money in the foreign exchange market. The rest either earn next to nothing or lose money.
  • From 10 projects only two takes off. This project brings the main profit.

Now let's consider the phenomenon of the currency market. 20% of trades will bring you 80% of income, and 80% of transactions will provide only 20% of income. The same is true for losing trades: 80% of the losses will be in the 20% of trades and 20% losses will be related to 80% of trades. Using this information, you can analyze you trades and create a new strategy, thereby increasing profits and minimizing losses at the same time.

Another postulate: 80% of the market price fluctuations occur over 20% of trading time. Therefore, if you constantly monitor the market and try to "catch" all the upper and lower points for opening/closing positions, then, spending 80% of the time, you will receive no more than 20% of the profits, the remaining 20% of the time will bring you 80% of all profits. As an example, the figure below shows the daily chart EUR / USD.

pareto forex

If a person's attention is scattered on a bunch of small cases or trades, the results will be worse than if he made a single trade, worked out to the last detail. Snipers are excellent analogy. They make only a few but well-placed shots, unlike ordinary soldiers who at best, shoot one enemy while spending all the ammo of an entire platoon.

In order to achieve maximum returns, the trader will need to conduct a detailed analysis. First, one has to select 20% of transactions that bring the main profit and 20% of the most unprofitable trades. It is necessary to pay attention to what one was thinking when making trades and to use in the future those approaches which bring the greatest profit.

By analyzing trade history trader can allocate 20% of his most successful and profitable trades, to investigate the causes of success, as well as explore 80% of less successful trades. By conducting such an analysis, one can achieve higher profitability, and by analyzing 20% of the most unprofitable transactions, one can eliminate the factors that caused the loss from ones strategy, thereby improving the efficiency of your trade.

It may look surprising but after such an analysis total income will grow but the approximate 20/80 ratio will always be maintained in ones trades. In other words, if before analysis trader made $1000 on 10 trades. 

From these 10 transactions 2 transactions brought 800 dollars, and 8 other transactions brought only 200 dollars. After the analysis efficiency will grow and the total income will be 2000 dollars, but still - 2 transactions will bring 1600 dollars and the remaining 8 will bring only 400 dollars.

Conclusion

The Pareto principle is an effective tool that will allow you to change any area of your life. Having understood the key principle, traders will have an advantage over other participants of any market: be it stocks, commodities or Forex.

Having developed the habit of applying the rule every day, a person can be one step ahead of others. And, as is already shown, the method works flawlessly. Just imagine how much life will improve if you spent 20% of your efforts perfectly!

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