PARETO PRINCIPLE (80:20)
What Is The 80-20 Rule?
roughly 80% of the effects come from 20% of the causes
For example; it is an axiom of business management that "80% of sales come from 20% of clients.
or that 20% of pea pods planted account for 80% of peas harvested.
80% of the comments on facebook come from 20% of the users.
80% of a countries wealth is held by just 20% of its population.
You might think when seeing the 80-20 rule that I am talking about putting 80% of your money into equities and the other 20% into fixed income holdings. But you would be wrong. The 80-20 rule has nothing to do with your overall allocation. It goes much deeper than that.
Fast forward to the 1940’s and Joseph Juran applied this idea to business. He showed that during the manufacturing process, 80% of the problems in quality control resulted from 20% of the defects. Therefore, if a business focused on correcting 20% of the defects, they would see a large spike in better quality items.
One important point about the Pareto Principle is that it is not hard and fast. What I mean by this is that it won’t always be that 20% of customers make up 80% of a company’s profits. It could be 25% of customers make up 90% of profits. So don’t get set on 80-20. The point is the idea that the majority of results comes from a small set of activity.
The 80-20 Rule in Investing
When investing, You will find that 80% of your returns come from 20% of your holdings, and 80% of your losses will come from 20% of your holdings. To succeed with the 80-20 rule when investing, you have to pay attention to two things.
#1. 80% of your success hinges on 20% of your actions
You could spend countless hours trying to pick great stocks, creating stop-loss orders, and such but at the end of the day, there are just a few actions you should be focused on. These few actions will make up the bulk of your success.
So what are these actions? You should figure out what your ideal allocation should be based on your risk tolerance and you should make it a point to rebalance regularly. If you can do these two things, you will experience success the majority of the time.
#2. 80% of your returns come from 20% of your holdings
So how do you make sure you are only holding winners and not losers? While history doesn’t always repeat itself, your first step should be to look at the winners in the stock market now. Who is not only succeeding today but is poised to succeed in the coming years?
Nvidia
Walmart
Netflix
Amazon
These are just a few. You might be tempted to look at some beaten down stocks like General Electric or Rite Aid and think you should take a flyer on these. But remember that 80% of your returns are from 20% of your holdings.
While General Electric is beaten down, it isn’t turning the corner any time soon. It wouldn’t surprise me if the stock is still trading around $20 per share 3 years from now. In that time, you could invest in Nvidia and potentially double your money.
Final Thoughts
The 80-20 rule plays out in all areas of our lives, including investing. Remember the two keys that 80% of your returns come from 20% of your holdings and that 80% of your success comes from 20% of your actions.
This is really cool. Good work.