Why Vilfredo Pareto's 80/20 Rule is so Important

Despite the latest monthly labor market data out of the US, there isn’t much to discuss as it pertains to last week’s market movements.

 US yields were slightly weak and the USD was slightly strong. There was no significant shift in the market’s perspective as to the timing of the Fed’s first rate hike. The higher probability remains that the first hike comes in either September or December of this year.

 Today, I’m going to focus on the historical performance of the trade ideas in TWR and the 80/20 rule, Pareto’s Principle.

 The greatest trading edge you can develop to consistently outperform is the ability to determine what is happening now.

 Half of the market participants are driving while looking in the rear view mirror, focused on what has already happened. The other half spends their days trying to forecast whats going to happen in the future.

 If the statistical reliability of weather forecasts falls apart after just 8 days, how in the world can you expect to forecast what's going to happen months from now in an ecosystem as complex as the global economy?

 Develop a process that allows you to better understand the current environment and you will be far ahead of your fellow investor. Helping you to better understand what is happening now has been the main focus of TWR over the last two and a half years.

 The performance numbers would say that so far, we’ve done a bang up job. I have been publishing The Whaley Report for 134 weeks now, or just over 2.5 years. The cumulative performance of the trade ideas over that time is 57%. This translates into an annualized rate of return just under 20% per year.

 So far this year, the year-to-date performance is 21.4%, which puts TWR in the top 0.13% (#41) of all 29,638 mutual funds tracked by Morningstar and is absolutely slaying the S&P 500 Index’s return of 1.8%.

 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. And the commissions mutual funds pay to trade are not reported in the performance number that Morningstar publishes.

 

Losing Is For Winners

 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, 60 out of the 108 ideas, to be specific. 

 On a weekly basis, we’ve been profitable only 59% 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 108 trade ideas over the last 134 weeks, the top 8 of those trade ideas have produced all of the returns, 57.4% to be exact. 

 Which means, that the other 100 trades produced a total return of -0.40%.  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 59% of the last 134 weeks. However, all of our cumulative return of 57% came in the top 6 weeks alone. So, the other 128 weeks provided a cumulative return of -1.15%. 

 On a weekly basis we are exhibiting 100/4 rule. 100% of our cumulative return is coming from just 4% of the weeks we traded.

 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. 

 he flip side of the trade ideas stats is that if you didn’t trade the 8 trade ideas that produced all of the return, then you lost money. Or if you missed just the top 6 weeks of the last 134, you met with a similar fate.

 TWR had 5 different 3-week periods of consecutive losses during the time I’ve been publishing. We also had stretch where 20 out of 28 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, like ours. It should be pointed out that the maximum drawdown for TWR trade ideas over the last 2.5 years is just 10.1%.

 A maximum drawdown is the largest single drop from the peak of an account’s value to its lowest point. Considering the 20% per year annualized returns of our trade ideas, a 10% drawdown is extremely palatable.

 To put this drawdown statistic in perspective, our 20% annualized return puts TWR in the top 4% of all mutual funds with a similar length of track record (just over 25,000 funds) tracked by Morningstar.  The average worst 3-month return for all of the funds who under performed TWR over the last 2.5 years is -26%. Over that same time period, TWR’s worst 3-month return was -5.5%.

 In addition, the average best 3-month return was 25%; TWR returned 46% during its best 3-month time period.

 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.

 Despite our trade statistics following Pareto’s principle, TWR has outperformed 96% of the mutual fund universe since its inception with just half of the worst-case volatility of that same universe.