ONE OF THE MOST

influential though seldom mentioned economists of the 20th century was Vilfredo Pareto, an Italian who in 1906 developed a simple mathematical formula now widely known as the 80/20 rule. Although other scholars have subsequently refined it, the basic idea remains the same: In almost all cases, the vast majority of the results are created by a small number of causes.

Although it's most commonly applied to sales and management issues, the 80/20 rule applies to trading quite well. Despite the high premium often placed on being a good stock picker, I've found that the vast majority of profits come from a small handful of trades. And while picking a stock that drops isn't fun, it's the cost of doing business and can't be permitted to derail one's confidence. The best traders are selective in where they put their money to work. They can't bet on everything; what counts is focusing on only their top ideas.

As I always point out, the point of investing is to make money. It would be quite convenient if every investment rose a comfortable 10% but in reality, it's always a small handful of big winners that account for the majority of a portfolio's overall return.

Profitable Trades
APPLET PLACEHOLDER: archive=Multipie.jar height=200 width=245

The lesson of the 80/20 rule is to focus on the 20% that actually matter. While many stocks go nowhere at all, investors who have the patience to let their winners run will usually find two or three trades a year that can rise 50% or more. A relatively small amount of risk capital produces the lion's share of the overall gain.

Of course, traders never know in advance which investments will be the important 20%. Some are intent on making money with a specific stock; it's the flexible traders who don't fight a trend, but follow it. Although they were certain that XYZ was the next big thing, if the market isn't confirming this suspicion, good traders are humble enough to move on.

Just as only a small percentage of winners will garner big gains, the 80/20 reality of trading is that an equally modest number of trades ever become winners in the first place. In my experience, I'd say close to 80% of my total trades are either break-even "scratches" or downright losers. I'm "right" only about 20% of the time. But by focusing on keeping the losses small, the relatively few number of winners more than make up for the stocks that drop or go nowhere at all.

Total Trades
APPLET PLACEHOLDER: archive=Multipie.jar height=200 width=245

Of course, what usually cripples investors isn't the market, but their own self-destructive loss of discipline. Because many of trades will be downright wrong, investors must to learn to emotionally let themselves off the hook. Yet what motivates many traders isn't making money, but being right. So when XYZ moves five points against them, they don't just chalk it up as a loss and move on, but obsessively add to the position, intent on saving face more than money. I've been there, and trust me: You inevitably end up losing both.

The lesson of the 80/20 rule is being able to handle the 80% of trades that don't work out. Being wrong, even on a majority of trading ideas, matters only to the extent that the trader can't deal with it. As a veteran of far too many shame spirals, let me tell you: A disciplined approach beats going from the gut every time. Remember, it's managing the trade not simply picking a stock that has the biggest impact on the bottom line. Repeat this to yourself often enough, and dumping an investment becomes as mundane as taking out the trash.

There are thousands of investment options out there and some people act as if it's their constitutional responsibility to have positions in as many of them as possible. This results in far too many portfolios being a patchwork of ideas rather than a few strategic themes. There's a big difference between being diversified and being disorganized.

As I often point out, traders can't invest in everything. Selectivity is crucial. Trading for the mere thrill of it results in far too many suckers' bets. It's a losing approach.

Out of the total number of trades I consider, I focus on only the top 20% of my ideas. It's just too expensive and time consuming to put money to work on anything but my best.

Choosing the Cream of the Crop
APPLET PLACEHOLDER: archive=Multipie.jar height=200 width=245

So don't just buy a stock because you know the company, like its product or hear it mentioned on cable TV. To quote Gordon Gekko, "I look at a hundred deals a day...I choose one." You should be equally discriminating. The trades I make are those I feel compelled to make out of my own selfish interest. They don't just excite me they keep me up at night.

Although the 80/20 rule wasn't developed for traders, it's relevant nonetheless. Whether you're evaluating your profits, trades or ideas, the lesson is always the same. First, focus on what matters. Next, run with it.

Jonathan Hoenig is managing member at Capitalistpig Asset Management, a Chicago-based hedge fund.