What Is the 80-20 Rule?
The 80-20 rule is something many people recognize in their everyday life, but not always consciously. What is the 80-20 rule? Officially known as the Pareto Principle, it’s an aphorism that’s often used to describe the lopsidedness of input-output forces. It’s named after Italian economist Vilfredo Pareto, who, in 1896, observed that 80% of Italy’s wealth belonged to 20% of the population.
Since his original observation, Pareto’s principle has become part of everyday life. For investors specifically, knowledge of the 80-20 rule can help you better-understand your portfolio’s performance. More than that, it’ll help you make smarter investments. Here’s a look at the 80-20 rule and how to apply it to your investing outlook.
Understanding the 80-20 Rule
The core concept of the Pareto Principle is an inverse relationship showing that 80% of X results from 20% of Y. The relationship is disproportionate by nature, meant to draw attention to inequalities that exist between certain related variables.
In the world of investing, the Pareto Principle is often cited to describe portfolio performance. For example, you’ll likely hear that “80% of your portfolio’s wealth comes from 20% of your holdings.” It’s important to realize that, while often very close in approximation, the 80-20 rule isn’t so much a rule as a benchmark. It’s meant to guide your thinking to focus on the 20% of factors that drive 80% of results.
It’s important to recognize the 80-20 ratio as a relationship, not as a sum total of 100%. The 80-20 rule focuses on cause and effect, not parts of a whole. It’s also vital not to misinterpret the rule as a way to nullify something. For example, if 80% of your portfolio’s value comes from 20% of its holdings, it doesn’t mean you should sell off those other holdings! Instead, let the Pareto Principle guide the outlook behind your actions.
How to Use the Pareto Principle When Investing
The 80-20 rule is an important tool for investors because it can help you avoid cognitive biases. For example, you might see that 80% of your portfolio gains come from a few ETFs as opposed to a dozen hand-picked stocks. When the time comes to invest again, it might be a smart idea to put money into an ETF as opposed to trying to double-down and “buy the dip” on stocks.
The 80-20 rule is most beneficial when it comes time to rebalance your portfolio. By focusing on the 20% of your holdings that generate 80% of the wealth, you’ll have an easier time cutting losses elsewhere. It’s a useful strategy for investors who get sentimental about their holdings or who constantly fight the urge to invest emotionally.
Finally, the Pareto Principle can factor into how you balance your portfolio. For example, it’s wise to place 80% of your money in stable funds and allocate 20% of your holdings to volatile growth stocks. The Pareto Principle helps mitigate investment risk by identifying it.
Evidence of the 80-20 Rule in Market Performance
Want to see the Pareto Principle in action? Look no further than a major index like the S&P 500. True to the rule, the top 20-ish companies drive 80% of the index’s growth and movement. The same goes for the Dow Jones Industrial Average, the Russell 2000 and other index funds. The reason is simple: This small segment of movers and shakers represents the largest and most prolific companies on the market today.
Consider just some of the top 20 companies in the S&P 500. These companies and others in the top 20% move the needle more than the other 80% because they’re entrenched in the everyday fabric of our lives. Dozens of companies in the S&P 500 might have a banner day with 4% gains, but if the top 20 companies post losses, the entire index will show red.
Other Applications for the 80-20 Rule
Investing isn’t the only place the 80-20 rule shows up. It’s most commonly used in business to identify the key actors driving performance. Some of the most common aphorisms include “20% of customers drive 80% of sales” and “20% of employees do 80% of the work.” This also applies to something like inventory – only inverse. For example, 80% of your inventory will represent 20% of your bestselling products due to demand.
The Pareto Principle applies to everything from personal finance to the time we spend sleeping each night. The key is remembering that a majority of results come from a minority of inputs. Train your brain to think about the relationship between the most important variables driving the largest number of outcomes.
The Vital Few and Trivial Many
What is the 80-20 rule? It’s a lesson on “the vital few and the trivial many.” While not a hard-and-fast scientific rule, it’s more of a lesson in perspective. The next time you open your brokerage account, take a look at your historical returns. You’re likely to see that 80% of your portfolio’s gains come from 20% of your holdings.
Once you understand the 80-20 rule, use it as a layer to better understand investment performance. For example, if you see that the S&P 500 is down, probe deeper to see whether the losses come from the top 20 companies. Or, if you’re interested in an ETF, consider where 80% of its gains come from. The more you get into the habit of identifying the vital few and the trivial many, the more adept you’ll become at capitalizing on the former and avoiding the latter.