StockFetcher Forums · General Discussion · The Pareto Principle, sometimes called the 80/20 Rule<< >>Post Follow-up
TheRumpledOne
6,358 posts
msg #49713
Ignore TheRumpledOne
modified
1/30/2007 4:56:33 PM

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Noise

Much out cry, little outcome...Aesop

The Pareto Principle, sometimes called the 80/20 Rule is something traders must heed, both in the markets and in life.

Originally, the Principle was a mathematical formula created in the early 1900's by Italian economist Vilfredo Pareto, and was use to describe the way in which wealth was distributed unequally. In essence, he calculated that 20% of the people possessed 80% of the wealth. Despite the controversy over how Pareto's original formula was translated and transformed, the fundamental thesis is valid today. Sometime around 1935, Joseph Juran coined the phrase "the vital few and the trivial many" in an attempt to elaborate on the work of Pareto.

80% of traders are in a state of reacting to what they perceive to be urgent and critical information. The constant message on TV now is "Breaking News" as if everything is breaking, important, necessary to be assimilated, will affect your trading positions and must be acted on NOW. This 80% needs almost constant guidance, is hurled from side to side on a sea of information and is in a state of almost continual crisis management. This, in and of itself, is a drawdown on psychological capital, due to the amount of energy which is necessary to put forth in order to keep with the barrage. In the end, 80% of the people are REACTING TO NOISE.

The remaining 20 percent are RESPONDING. They open themselves up to the possibility that anything can happen and are able to be still in the midst of chaos as they wait quietly and patiently for opportunity. The markets are changing constantly, things are always going up and down. Learn the lyrics to the Kenny Rogers Song: The Gambler and try to live and trade that way.

It is in your best interest, both in trading and in life, to become less reactive and more responsive. In order to achieve this, one must cultivate a centered, reasoned state of balance. One must learn to sit comfortable in the pain of being presented with multiple choices, rather than to grab whatever is being tossed out at the time. Sit quietly, think, allow your brain to melt into a distant observer, and your body to become still. Be the eye of the hurricane and try to avoid the tyranny of the urgent. Know when to do something and when to do nothing. Your trading and your life will improve once you are able to turn down the noise and focus on what is really important to your bottom line.

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Your Rat Brain Is Out To Get You

People are neurotic and the markets, since they are large collections of people, are also neurotic.

We are neurotic because we are in constant conflict with ourselves, specifically as regards our brain structure.

In the simplest of terms, we have two brains- and old brain and a new brain. The old brain is primitive, lies deep within the new brain and has been around for at least 100,000 years. This is the rat brain or limbic area that subserves emotion and instinct and caused our ancestors to run up a tree when the grass started to move just in case there might be a lion lurking around somewhere.

This is our emotional, greedy, needy, old rat brain which is constantly telling us "Yes, yes, yes!" Eat more, drink more, have more sex, take lots of risk, grab for all the gusto you can get, run away quickly when you are threatened or feel danger, run in quickly when things seems so wonderful, and, above all DO NOT THINK! The rat brain is irrational.

As the human brain evolved, the old rat brain became encased in and covered over by the new brain called the neocortex. This is the new thinking, analytical, calculating, rational brain. Every time the rat brain says "Yes, yes, yes", the rational brain says "No, no, no." Don't do that because it is dangerous, makes no sense, is self-destructive, is not in the best interests of you or your family or society, is not smart, could cause you damage, is illogical.

We are hardwired to make bad financial decisions because of our limbic rat brain. The rat brain is not capable of evaluating risks and projecting them into the future. It reacts immediately, instinctually and without thought. Inexperienced traders (and even some of the most experienced), when faced with a conflict between rationality and emotions, will act on emotions. The old rat brain wins the battle and it wins over and over again.

Aversion to loss, which is a disproportionate fear of risk makes a lot of sense from an evolutionary standpoint when we were in the jungle running from wild animals, but makes no sense whatsoever in the markets. When we see a stock or future position falling, our brain (and body, but that is another topic altogether) reacts as if we are being threatened. Dumping a position when you see it falling is like running up a tree because you THINK a lion might be lurking. Running up a tree won't hurt you, but dumping a position on emotion can wipe you out. That is panic selling.

How often have you done this? Panicked out of a position only to see it turn around in minutes to days? That is your rat brain in charge and your logical brain completely taken over by emotion.

It also works the other way. When you see a stock going up and up every day, the rat brain tells you that it will continue to go up and you better get in now because you are missing out. This is panic buying. You get in and the stock starts to fall so you panic out of it as well.

This is why most traders buy high and sell low. Their rat brain takes over and they are powerless against it. The rat brain wants results NOW. The new brain is patient and waits and analyzes.

Our goal on the path to becoming successful traders is to understand ourselves, deeply and on a minute to minute basis when we are in the midst of making financial decisions.

For now, try to tune out the noise and constant barrage of information. You will feel greedy when you should be feeling fearful and fearful when you should be feeling greedy, This is your rat brain playing tricks on you!




killertrader
18 posts
msg #49714
Ignore killertrader
1/30/2007 5:20:57 PM

I majored in Economics a long time ago. I can still see my professor going around the room screaming "Pareto Optimality, Pareto Optimality!" Our whole exam was on pareto optimality. Thank you TRO for taking me back. Please kill me now.


stocktrader
293 posts
msg #49735
Ignore stocktrader
modified
1/31/2007 10:16:11 AM

Funny, killertrader.

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This is what makes me money, as stated in TRO's post above "wait quietly and patiently for opportunity". We've probably all heard the statement, let the trade come to you and don't chase a stock. This is so true.

I only trade intraday, and every morning I sit and "watch" my watch list very patiently. After I see panic buying or selling I jump in with a long or short position. There may by only 1 opportunity during the first hour of trading or the entire day, for my watch list. But, I make money.

So, next time we see a stock running up quickly, ask ourselves, do we want to be holding the bag?

Trade well.




StockFetcher Forums · General Discussion · The Pareto Principle, sometimes called the 80/20 Rule<< >>Post Follow-up

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