From the Archives: The 80/20 Rule in Action

According to a fascinating study discussed in Time Magazine based on 27 million hands of Texas Hold’em, it turns out that the more hands poker players win, the more money they lose!  What’s going on here?

I suspect it has to do with investor preferences–gamblers often think the same way.  Most people like to have a high percentage of winning trades; they are less happy with a lower percentage of winning trades, even if the occasional winner is a big one.  In other words, investors will often prefer a system with 65% winning trades over a system with 45% winning trades, even if the latter method results in much greater overall profits.

People overweigh their frequent small gains vis-à-vis occasional large losses,” Siler says.

In fact, you are generally best off if you cut your losses and let your winners run.  This is the way that systematic trend following tends to work.  Often this results in a few large trades (the 20% in the 80/20 rule) making up a large part of your profits.  Poker players and amateur investors obviously tend to work the other way, preferring lots of small profits–which all tend to be wiped away by a few large losses.  Taking lots of small profits is the psychological path of least resistance, but the easy way is the wrong way in this case.

—-this article was originally published 2/10/2010.  Investors still have irrational preferences about making money.  They usually want profits—but apparently only if they are in a certain distribution!  Real life doesn’t work that way.  Making money is a fairly messy process.  Only a few names turn out to be big winners, so you’ve got to give them a chance to run.

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