Pareto's Principle

As you might expect in a week when U.S. markets are only open three and a half days and volume across most markets is about half of the average; there isn’t much worth discussing as it pertains to financial markets. 

 This week’s report is going to be a bit shorter than most but I’m going to focus on mistakes and the 80/20 rule, Pareto’s Principle.

 I have been publishing The Whaley Report for 82 weeks now.  The cumulative performance of the trade ideas over those 50 weeks is 40.4%.  The 2014 year-to-date performance is 10.1%, which puts TWR in the top 7% of all 29,664 mutual funds tracked by Morningstar and just slightly ahead of the S&P 500 Index’s return of 8.30%, so far this year.

 TWR’s relative returns are very solid on their own.  The returns become more impressive when you factor in the low commission costs of implementing the trade ideas.  There are a low number of trades with long holding periods, only 1 trade each week with an average holding period of 25 days.  It’s important to note that the commissions mutual funds pay to trade are not reported in the performance number that Morningstar publishes.


Winning And Losing

But how did we get here?  If you follow the trade stats that I update each week, then you already know that over half of the trade ideas I’ve published have been losers, 44 out of the 82 ideas, to be specific.  On a weekly basis, we’ve been profitable only 58% of the time.

 So how did I manage above average returns, lower turnover (and expenses) and still lose more than half the time? It’s all about the power of the 80/20 rule: 80% of a set of results comes from only 20% of the action taken.

 Evaluating our 82 trade ideas over the last 82 weeks, the top 6 of those trade ideas have produced all of the returns, 41.1% to be exact.  Which means, that the other 76 trades produced a total return of -0.77%.  So in our case, it’s the 100/7 rule.  100% of our returns have come from only 7% of the trade ideas initiated.  The other 93% of trade ideas were essentially a wash.

 Now let’s apply the 80/20 rule to the weekly returns of the trade ideas.  As I stated earlier, we were profitable in 58% of the last 82 weeks.  However, all of our cumulative return of 40.4% came in the top 4 weeks alone.

 So, the other 78 weeks provided a cumulative return of -1.16%.  On a weekly basis we are exhibiting 100/5 rule.  100% of our cumulative return is coming from just 5% of the weeks we traded.


The Bottom Line on Performance

Two things pop out from these two sets of statistics: first, the numbers are eerily similar and two, we are clearly seeing 80/20 rule dynamics at work here.

 There are two reasons that I chose to drill down on the trading statistics of my ideas.

 First, the entire premise of The Whaley Report is based on the 80/20 rule concept.  It started with research to determine the handful of markets that could replicate most of the returns of the financial markets on a calendar year basis.  And it continues, each week, by finding the 20% of information, data and stories that will provide 80% of the markets price movement.

 The second reason I think these underlying trade statistics are important is because it shows the importance of having conviction in and following an investment process.  The flip side of the trade ideas stats is that if you didn’t trade the 6 trade ideas that produced all of the return, then you lost money this year.  Or if you missed just the top 4 weeks of the last 82, you met with a similar fate.

 TWR had three different 3-week periods of consecutive losses during the last year.  We also had stretch where 17 out of 21 closed trades were losers.  It’s critical during bad stretches like these, which are bound to occur in any trading process, to have conviction in the way you are making decisions.  It certainly helps if your process produces winning trade ideas that are, on average, twice as large as your losses.

 Any investment process can be “wrong” for short periods of time but the more critical question is how does that process perform year-in and year-out over long periods of time.