Stock Market Video
Little Causes, Big Effects, The 80–20 Rule
This Week’s Fortune Cookie
In Case You Missed It
In this week’s video, Mike Cintolo, editor of Cabot Market Letter and Cabot Top Ten Trader, talks about the general market, which is on the fence. But he expands much more deeply into what he thinks is the biggest story of the market during the past three weeks—the growing divergence between the broad market and leading growth stocks. And he tells listeners why this can actually be a good thing for growth investors! Click below to watch the video!
There was a commonly held rule in my family, developed (and likely borrowed) from somewhere in the deep past, that you could do 90% of the job of moving stuff from one house to another in 10% of the time. But it would take 90% of the time to get rid of the other 10%.
And it’s true. Once you get the furniture, appliances and books into the U-Haul, it seems that you’re almost ready to shove off. But getting all the miscellaneous trash and treasures from the depths of the kitchen cabinets, the basement, the shelves in your closet and, worst of all, the attic, seems to go on forever.
Interestingly, the world is filled with this kind of disproportion in time and effort. In fact it seems that there is a universal principle that the distribution of everything is uneven.
Take, for instance, my old favorite from my statistics class, the Pareto Principle, a proposition stating that 80% of the effect in any set of circumstances is always produced by 20% of the cause. [Note: I suspect that the Pareto Principle is the real origin of my family’s 90-10 rule about moving, with a few adjustments for dramatic effect.]
The Pareto Principle was named after Vilfredo Pareto, an Italian economist who noted in 1906 that 80% of all the land in Italy was owned by just 20% of the population. When Pareto began looking at land ownership in other countries, he found that the results were almost exactly the same. (He also found that it applied to the production of peas in his garden, but I don’t want to make him sound like a crank.)
This principle was picked up by analysts in other fields, and they all found similar 80-20 distributions. It was found, for instance, that 80% of any country’s population lives in 20% of the country’s cities; that 80% of the area burned in forest fires came from 20% of the fires, etc. The rule applies to the size of meteorites, the size of casualty losses in many types of insurance, and, most interesting to me, the standardized price returns on individual stocks.
The mathematics that have been used to make sense of the Pareto 80-20 Principle make my head spin. (If you Google “The Double Pareto-Lognormal Distribution—A New Parametric Model for Size Distributions,” you’ll see what I mean.) But I think there are a couple of very commonsensical, very important conclusions from taking The Principle seriously in growth investing.
First, the 80-20 rule tells me that picking growth stocks is not really that complicated, although you can make it complicated if you want to. The biggest improvement to your stock selection will come from relatively little effort. If you have been buying stocks based solely on their story (a very common occurrence, believe me), you will get the biggest improvement from a simple review of revenue, earnings and margin trends for the last few years, then taking an educated look at the stock’s chart. Finally, you can check the major trend of the market and you’re good to go.
You can locate tons more material on any given stock by just rooting around on Yahoo Finance or using your online broker. You can check out the company’s competition, corporate debt, cash reserves, research budget, qualifications of the C-level officers and data-mine the annual report all you want. But you won’t ever achieve certainty about the stock’s likelihood of making you money.
It’s pretty much the same situation with your own personal health. You can spend days and weeks reading health websites about how to live longer and better. But ultimately you will get the most out of just a few common pieces of advice. Once you get past “Stop smoking, lose a little weight, get some exercise and a bit more sleep, don’t drive like a maniac and try to keep a positive attitude,” you’ve probably hit your 80% improvement mark. And obsessing about your chromium levels or getting your colon cleansed are probably well down the road of diminishing returns.
Second, if you remember that 80% of your total return for any given year will be attributable to just 20% of your stocks, you’ll take the task of selling your losers more seriously. Because the 80-20 rule also applies to your losses. We all know that a big loss in a stock has dire consequences for your portfolio. It draws down your capital and you need a much bigger gain in the stock to recover it. And the larger the loss, the harder it is to make it up.
Cabot’s loss-limit disciplines direct you to sell any stock that is down 20% from your buy price at the close of a trading session. That’s a maximum loss during a period when the markets are healthy. When markets are in a downtrend, you should reduce your exposure (curtail buying and hold cash) and lower your loss limit to a maximum of 15%. And we will often take losses of 10% or even less is the stock isn’t acting well.
If you can reduce your loss totals, 80% of which are produced by just 20% of your portfolio, you can make huge strides toward winning big for the year.
I’m always interested in the insights that a few simple statistics can produce. But when statistical rules begin to affect my wallet, I’m absolutely fascinated. I hope this has been informative for you, as well.
Tim’s Comment: It’s true in theory, but reality is messier. In recent years, Communist China has embraced a controlled form of capitalism that has helped boost the standard of living there immensely (with the side effect of horrible smog), while Capitalist U.S. has taken unprecedented steps to stimulate the economy by bailing out debt-burdened entities large and small and worked hard to improve our inefficient health care system by making health care more available to all. Where these trends lead will be interesting, but speculation brings little reward; it’s more rewarding to work at finding good stocks.
Paul’s Comment: This is a fine sentiment, if a little dewy-eyed about the high moral principles of capitalists. In my experience a capitalist is more likely to say “I want it for myself” than worry about the living conditions of his fellow men. But it’s certainly true that communists were all about equality in theory but selfishness in practice. Capitalism builds lots of fine homes, and offers them to whoever can come up with the money. The trick is to figure out where the money is to be made and either start the business or buy the stock.
In case you didn’t get a chance to read all the issues of Cabot Wealth Advisory this week and want to catch up on any investing and stock tips you might have missed, there are links below to each issue.
In this issue, Stock of the Month honcho Tim Lutts looks at the stock market’s fixation on interest rates and inflation. He concludes that spending time finding great growth stocks beats time spent worrying about inflation. Tim also discusses the fifth of his Revolutionary Stocks: Quidel Corp. (QDEL).
In this issue, I wonder where the Next Big Things will come from, now that Moore’s Law is running into some resistance from the laws of physics. My stock pick could be a Next Big Thing: it’s a Chinese company that’s a combination of Facebook (for the social media aspect) and YouTube (for the sharing of videos element)
Options expert Jacob Mintz describes a Stock Replacement strategy that allows you to lock in profits on your stock to reduce your risk while still giving you exposure to the stock’s upside.
Have a great weekend,