Wednesday, 13 July, 2011

Pareto Principle

Pareto Principle

There are a few principles that stand the test of time.
Pareto principle is one such. The old, famous, 80-20 rule.
The picture below explains it eloquently:
To the best of my knowledge, Pareto principle works perfectly in all walks of life (at least in 80% of the situations).
All the more so, in the world of personal finance, especially in the wonderland of shares & equity mutual funds.
Some of the things that I've observed:
  • 80% of the profits that you derive come from 20% of your investment decisions

  • 80% of the profits that you derive come from 20% of your shares & mutual funds

  • 80% of the total losses that you incur in each year comes from 20% of your shares & mutual funds

  • 80% of profits (and losses) are generated in 20% of your holding period of the concerned investment (unfortunately, as David Ogilvy would have perhaps said, you don't know which 20% - Hence it makes sense to refrain from trying to time the markets!)

  • 80% of what you hear / read / listen to from public sources are either unreliable or have already been factored in by the markets already

  • 80% of the "secret tips", "sureshot advice" that you get from friendly brokers, neighbours, relatives, colleagues, well-wishers are junk material

  • 80% of such junk material referred to above are very tempting to act upon. 

  • 80% of our actions based on such advice referred to above result in losses

  • 80% of ALL short-term predictions that you act upon are totally wrong, misleading, unreliable, useless or all of this and more!

  • 80% of ALL short-term players, traders, self-learnt share "dabblers" lose money. Often lose the principal.
So, what does one do?
For those of us who are not making 80% of our total income from trading in shares, it does not make sense to "trade" at all!
Instead, the 80% of us who are not making 80% of our TOTAL INCOME from trading in shares must become investors in the true sense of the term.
And follow some basic norms such as:
  • Don't forget - It is your money that you are investing. Never lose the capital. Don't take a risk that you can't accept. Mentally or financially.
  • Do not buy before doing your own research - Really.
  • Do not invest in shares if you are unwilling or incapable of holding the shares for at least 3-5 years. Really.
  • Do not expect returns which are more than double what you get from a fixed deposit in a public sector bank.
  • Do not hesitate to book your profits when you get your expected returns. Especially when you get such profits in unexpectedly quick time!
  • Do not invest any money that you may require within the next 1-2 years
  • Do not invest borrowed money in shares
  • Just like you can't catch all the fish in a fishing trip, you will miss buying the right shares OFTEN and you'll sell too early - OFTEN. It is OK, as long as you don't end up buying the wrong shares and end up holding such junk for too long.
  • Do not invest ALL your investible surplus in a single company / sector / promoter group.
  • Do understand your risk profile and plan your asset allocation carefully before investing in shares.
  • If, in the unlikely event of your share zooming into the stratosphere after you bought it, just before selling it to book your profits, ask yourself: "Will I buy this share at the current price if I had the money?" - If the answer is an unequivocal "Yes", Don't sell right now.
  • The share market is not for historians. You deal with the future; you deal with uncertainties; you deal with probabilities; you deal with the unknowns. Be prepared by understanding the concept of "Maximum acceptable loss" and get out if your share price falls below this level.
  • The shares you have bought are not your parents nor is it your beloved spouse. Be willing to "Let go" and sell it - either to book profits or to minimise losses.
  • The share market does not owe you money. The share market does not know that you have bought a particular share. The share market will take the share prices up and down. The share prices will be volatile. Make volatility your friend. If not, it will become your worst enemy.
  • Investing in shares is not a game of cricket or chess or soccer. It is like manufacturing steel or creating software or making biscuits. You should not treat it as a game of chance or a game of skill. You should treat it on par with something like buying a house, for instance. Before purchasing a house, all of us go through a whole range of evaluation parameters.
All said, remember the Pareto Principle.
Learn to relax by focusing on the key 20% - Always.

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