Pareto Distribution

I don’t want to get into “An unauthorized analysis of MF results” but investors should be aware of the Pareto or 20-80 distribution. 20% of the stocks in a portfolio should normally produce 80% of the returns. It should not come as a surprise that one stock in particular created a large part of the profits.

Simply put, a loser in a long portfolio can only lose 100% but a winner can be a ten or a hundred bagger. Put more mathematically:

The Pareto distribution is a skewed, heavy-tailed distribution that is sometimes used to model the distribution of incomes and other financial variables.

You might be interested in one use I have for the Pareto Distribution:

February 20, 2011
Why Does the Average Mutual Fund Underperform?

It has often been stated that the average mutual fund underperforms the market but I have never seen an adequate explanation. I used to believe in a simplistic reason: Since mutual funds make up the average, if you deduct their management fees, their results will be that amount below the average. While this holds true, it is not the real reason. For an explanation we have to look at the Pareto Distribution of wealth.…

Denny Schlesinger