The Pareto Principle or the 80/20 rule in trading, as it’s more commonly known, asserts that 80% of all outcomes (consequences) can be attributed to 20% of all causes for any given event. Named after economist Vilfredo Pareto in 1906, the term was originally used to connect the relationship between wealth and people.
More specifically, Vilfredo noted that in Italy, 20% of the population owned 80% of the land, a distribution pattern he found to be prevalent in other countries across the globe.
Eventually, this principle was applied in other areas, e.g., management, human resources, business, etc. In the 1940s for instance, Dr. Joseph Juran, a leader in the field of operations management, applied the 80/20 rule to quality control for business production, observing that 80% of product defects were caused by 20% of the production problems. The Pareto Principle has since even been applied to personal time management, about the notion that 80% of a person’s work-related output comes from only 20% of time spent at work.
So how is Vilfredo’s 80/20 applied in the world of trading today? Let’s discuss.
Portfolio and asset management
It may happen that a small percentage of trades or investments in a portfolio account for the majority of profits or losses. In this case, a trader may find that optimizing this critical 20% can have a considerable impact on total portfolio performance (80%). By the same token, an investor may find that a smaller number of specific assets account for a higher return on investment. By identifying those assets, a trader is better able to plan their investments (and resources) more efficiently.
T4Trade traders for example can trade more than 300 instruments across 6 asset classes using the MT4 platform. This enables the trader to hone in on those instruments or asset groups that contribute more significantly to overall returns. In this way, the trader plans their investments more strategically, increasing the likelihood of making gains.
Risk management
Traders may observe that a smaller group of trades contributes disproportionally to their overall risk exposure. Identifying and properly managing those risk factors that impact trading outcomes may assist in reducing losses. What does managing trading risk look like though?
Building a risk management plan
It is of vital importance that a forex investor has a strategic risk management plan in place. The plan must align with the trader’s objectives, budget, and expertise. It must also take into account the 80/20 rule, with proper risk management measures in place to mitigate potential losses.
Being mindful of your risk tolerance
In the process of creating your risk management plan, ensure you consider the level of risk you’re willing to incur. This means setting a position size that you’re comfortable with and that doesn’t exceed your budget. It also ensures that you’re risking more than you can afford to lose on any given trade. At the same time, ensure you avoid overleveraging as while it can magnify your gains, it can also amplify your losses. Handle leverage responsibly to prevent margin calls or large capital losses.
Setting stop-loss and take-profit orders
A risk management plan should also include stop-loss and take-profit orders to ensure you don’t lose more money than you’re willing to risk.
Continuous learning
One of the most effective ways to manage risk better is to invest in ongoing learning. Acquiring an education, or enhancing existing knowledge continuously, provides you with much-needed knowledge and insights to be able to better identify risks and avert adverse trading outcomes. There are so many educational resources available online, that there is no reason a trader can’t arm themselves with the information needed for success.
For example, T4Trade offers its traders access to blogs, webinars, podcasts, ebooks, videos-on-demand, and live TV, all of which cover a broad scope of topics related to trading. This information is free to access and use, thereby helping an investor with little to no budget to invest in learning. Apart from T4Trade, the internet is packed full of trading-related resources for traders to consume. Just make sure you conduct your due diligence and follow only those experts who are reputable and don’t promise 100% gains with zero losses.
Using a demo trading account
A demo account is a great way to learn how to manage trading risk. The demo account offers a trader a way to practice their investments, and test out trading strategies, in a simulated trading environment that also offers real market conditions. In this way, a trader can identify key strengths and weaknesses and improve their trading plan/strategy accordingly. An investor can do all this using virtual funds, thereby safeguarding their capital whilst they gain the expertise. A demo account can also be used to learn more about technical and fundamental analysis, important skills required to manage risk.
Knowing how to analyze the market will help an investor make more informed trading decisions, thereby increasing the potential for mitigating the 80/20 rule. A demo account is a great tool for both novice traders and those with years of experience. For the beginner trader, it offers a way to build confidence over time, until the trader is ready to move to live trading. For a more experienced trader, the demo account can be used to test the most complex strategies and assess outcomes, to better plan future trades.
Analyzing the market
In the world of trading, what may appear as a small event or economic release (20%) has the potential to impact asset prices significantly (80%). This makes the monitoring of global news and events all the more important. One of the ways that traders seek to stay informed is through the use of an Economic Calendar, much like the one offered by T4Trade. This is probably one of the most useful tools for a trader dealing with the challenges of a volatile market and aggressive price fluctuations.
An Economic Calendar informs the investor of upcoming important events and economic data reports. Knowing the dates of key releases or events will help a trader better plan their investments, and adjust their strategies where necessary.
The calendar can also be used to monitor indicators and chart patterns that might be influenced or produced by these events or announcements. Top economic indicators include GDP, Industrial Production Index (US), Consumer Confidence, Inflation, Unemployment rates, Central Bank policies, Retail Sales, and others.
Trading with T4Trade
T4Trade offers traders a flexible trading environment through which they can trade 300+ financial instruments from 6 asset classes. This includes shares, indices, forex, futures, metals and commodities. T4Trade traders can choose from a variety of carefully crafted trading accounts, ensuring the needs of all types of traders are met, regardless of expertise.
Traders can also enjoy flexible leverage, tight spreads, quick deposits and withdrawals, and fast trade executions. A multilingual customer support team is also on hand 24/5 to address any of your trading concerns via email or Live Chat. T4Trade also offers traders access to exclusive forex and CFD-related content to help you become a better trader.
Disclaimer: This material is for general informational and educational purposes only and should not be considered investment advice or an investment recommendation. T4Trade is not responsible for any data provided by third parties referenced or hyperlinked in this communication.
