“Some years ago in my observation of P/L patterns, I noticed the following interesting trend: For virtually every account I encountered, the overwhelming majority of profitability was concentrated in a handful of trades. Once this pattern became clear to me, I decided to test the hypothesis across a large sample of portfolio managers for whom transactions-level data was available. Specifically, I took each transaction in every account and ranked them in descending order by profitability. I then went to the top of the list of trades and started adding the profits for each transaction until the total was equal to the overall profitability of the account.
“What I found reinforced this hypothesis in surprisingly unambiguous terms. For nearly every account in our sample, the top 10% of all transactions ranked by profitability accounted for 100% or more of the P/L for the account. In many cases, the 100% threshold was crossed at 5% or lower. Moreover, this pattern repeated itself consistently across trading styles, asset classes, instrument classes, and market conditions. This is an important concept that has far-reaching implications for portfolio management, many of which I will attempt to address here.
“To begin with, if we accept the notion that the entire profitability of your account will be captured in, say, the top 10% of your trades, then it follows by definition that the other 90% are a break-even proposition. Think about this for a moment: Literally 9 out of every 10 of your trades are likely to aggregate to produce profits of exactly zero. It almost makes you want to pack up your charts and go home, doesn’t it? Indeed, the main danger in being aware of this concept is the tendency to misinterpret its implications. For this reason, we want to be very careful about how we use the information in driving the portfolio management process and all of its components.
“Most people’s first reaction when they see their “90/10” score is to assume that it is a problem that wants correcting. This is simply not so; and if they respond by trading less, concentrating their portfolio exclusively on what they feel to be their best ideas, they are likely to be disappointed by the results. The 90/10 rule is hard to overcome, and so I think the better way of looking at it is that you need the 90 to get the 10. To best understand this, let’s use a baseball analogy (why not, everyone else does). Think of the situation faced by a .300 hitter in baseball, who, even though he knows he’s going to be unsuccessful 70% of the time cannot simply decline to step up to the plate on the 7 out of 10 occasions where (statistically speaking) he isn’t likely to get a hit. Truth is, the 7 outs he makes in 10 at-bats are a necessary condition of his .300 batting average, and he can no more expect to be more successful by limiting his at-bats than you can expect to be successful in your trading by reducing your number of transactions. True, just as the batter may know that he does better against certain teams and pitchers and in certain parks than others, so will you as a portfolio manager have some insights into the conditions that are most conducive to maximum profitability – across individual names, market cycles, and other factors. However, in both cases, the individual in question cannot expect to gain any benefit through a lack of participation.
“Therefore, the principal lesson you should derive from 90/10 may well be that the lower 90% of your transactions, which are likely to sum up to zero P/L, are a critical component of your success. If properly analyzed, these trades can provide insights into the controllable elements of your portfolio management activities that can be enormously valuable to your bottom line. However, if you fight against this tide, you are likely to fall into a large group of market participants who have very useful skill sets but who inevitably become their own worst enemies.”
– Ken Grant, Trading Risk
Certain aspects of successful trading are misunderstood by the majority of would-be traders, or worse yet never grasped at all.
This is another reason why the well-cited 90% failure rate in trading compares to the 90% failure rate of small businesses: A fair chunk of the trader / entrepreneur mortality rate can be attributed to a basic lack of knowledge.
A trader who overlooks key aspects of, say, risk management or the way the market distributes profits, for example, is like the baker who opens a pie shop assuming success will hinge entirely on the deliciousness of the pies, without realizing the life or death of the pie shop is just as much about abstract concepts like marketing ROI, cost containment and cash flow.
Ken Grant (the author of Trading Risk) has served as risk manager for some of the largest and most successful hedge funds in the world. He draws his conclusions from an observable universe of highly successful professionals. Among these traders, why do you think the 90/10 ratio is so prevalent? And what does it potentially say about critical success factors like consistency, position sizing, and risk control?
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