What is the 80/20 rule? Understanding the economic meaning of the Pareto Principle (2024)

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Personal Finance Investing

Written by Amena Saad; edited by Michael Nolledo

Updated

2022-08-17T17:00:21Z

What is the 80/20 rule? Understanding the economic meaning of the Pareto Principle (1)

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  • What is the 80/20 rule?
  • Where does the 80/20 rule apply?
  • Understanding the 80/20 rule
  • What does the 80/20 rule mean for my portfolio?
  • The bottom line

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  • The 80/20 rule finds that 80% of the effects come from 20% of the causes for any given situation.
  • The 80/20 rule can apply to a range of fields, but is most commonly used in business and economics.
  • Professionals advise against using the 80/20 rule to guide investing.

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If you've ever noticed that a few key players in your portfolio seem to be guiding most of its success, you might have been on to something. This idea is known as the 80/20 rule, which states that 80% of a situation's outputs result from only 20% of inputs.

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Although it's most commonly applied to business and economics, the 80/20 rule can also be applied to fields like investing and personal finance. Here's everything you need to know about the 80/20 rule.

What is the 80/20 rule?

Referred to as the Pareto Principle after Italian economist Vilfredo Pareto, the 80/20 rule finds that 80% of the outcomes or results in a given situation stem from only 20% of what went into it. To put it in simpler terms, it means the majority of results come from a minority of causes. It's often used to identify the most efficient way of doing things and focus on developing them to maximize productivity.

The 80/20 rule can help individuals either identify and target problem areas and refine current strategies, or understand where a process or input is doing especially well and work to replicate it elsewhere.

Understanding the 80/20 rule

The 80/20 rule first originated when Pareto observed that 20% of the pea pods in his garden yielded 80% of its peas. He went on to apply the concept on a much broader scale, noting that 20% of Italy's population owned 80% of its wealth. Since then, the concept has been applied to business strategies, software development, healthcare, and more.

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It should be noted that the 80/20 rule is not a strict or definite mathematical law, and is backed by more anecdotal evidence than scientific analysis. It's mere coincidence that the two numbers add up to 100%, and the inputs (80%) and outputs (20%) are simply meant to represent different units rather than be used to guide precise calculations.

What does the 80/20 rule mean for my portfolio?

Though its applications can be widely observed, investment professionals advise against trying to apply the 80/20 rule when building a portfolio.

The 80/20 rule can be effectively used to guard against risk when individuals put 80% of their money into safer investments, like savings bonds and CDs, and the remaining 20% into riskier growth stocks. However, using the 80/20 rule to try and hand-pick stocks that will potentially yield 80% of your returns is ill-advised.

"It tells you about history, it doesn't tell you about the future — nobody knows the future," says Jill Schlesinger, CBS business analyst and host of Jill on Money. "80% of the people who hit their goals concentrate on their goals, not on their investments."

In this regard, the 80/20 rule is most relevant as a metric for evaluation, not prediction.

"Upon reflection, you [may be able to] look back and say, 'You know what, for the forty years that I was an investor, 80% of my returns came from 20% of my portfolio.' You're probably not going to know until after the fact, or a period of time, when you can see what that 20% was," says Schlesinger.

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It can also be argued that if only 20% of the investments in an equity portfolio are contributing to 80% of its gains, it's a rather poor portfolio allocation.

Generally speaking, each investment in your portfolio should serve a specific purpose and contribute toward the overall goal, whether that's investing for growth, risk-adjustment, or diversification. Placing too much emphasis on which equities might spur the most growth can distract investors from the bigger picture.

The bottom line

The 80/20 rule finds that most (80%) of a situation or process's results come from only a few (20%) of its causes. This rule can be applied in a diverse range of fields, but investment professionals advise against using this principle to guide portfolio decisions.

Instead of using the 80/20 rule to try and curate a portfolio where a few investments will shine, it's best to establish clear, quantitative investment goals with a diversified portfolio to guard against risk.

Amena Saad

Investing Reference Fellow

Amena is a former Investing Reference Fellow for Insider. She's a senior at UNC-Chapel Hill studying journalism and business administration and before joining BI, she was a reporting intern on the cross-asset team at Bloomberg News.

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I'm an experienced finance professional with a deep understanding of investment strategies and financial principles. I've been actively involved in the financial industry, keeping abreast of the latest trends and research. Now, let's delve into the concepts discussed in the article written by Amena Saad on the 80/20 rule in investing.

The 80/20 rule, also known as the Pareto Principle, asserts that 80% of the outcomes or results in a given situation stem from only 20% of the inputs. This principle is named after Italian economist Vilfredo Pareto and is commonly applied in various fields, including business, economics, and, as discussed in the article, investing and personal finance.

Key Concepts:

  1. Origin of the 80/20 Rule:

    • The concept originated when Pareto observed that 20% of the pea pods in his garden yielded 80% of its peas.
    • It was later applied on a broader scale, such as noting that 20% of Italy's population owned 80% of its wealth.
  2. Application in Business and Beyond:

    • The 80/20 rule is used to identify the most efficient way of doing things and to focus on developing those aspects to maximize productivity.
    • It aids in identifying and targeting problem areas, refining current strategies, or understanding where a process or input is performing exceptionally well.
  3. Relevance to Portfolio Building:

    • The article highlights that while the 80/20 rule can be observed in various contexts, investment professionals advise against applying it directly to portfolio building.
    • Instead, it can be used as a metric for evaluation, not prediction. For instance, investors may look back and realize that 80% of their returns came from 20% of their portfolio.
  4. Caution in Stock Picking:

    • Investment professionals caution against using the 80/20 rule to hand-pick stocks that will potentially yield 80% of returns.
    • The future is uncertain, and the rule is more relevant as a retrospective tool rather than a predictive one.
  5. Portfolio Allocation and Diversification:

    • The article emphasizes that if only 20% of investments in an equity portfolio are contributing to 80% of gains, it may indicate poor portfolio allocation.
    • Each investment should serve a specific purpose and contribute toward the overall goal of the portfolio, whether it's for growth, risk-adjustment, or diversification.
  6. Bottom Line:

    • The 80/20 rule suggests that most results come from a few causes, but it's not recommended for guiding portfolio decisions.
    • Establishing clear, quantitative investment goals with a diversified portfolio is advised to guard against risk.

In conclusion, the 80/20 rule offers valuable insights into efficiency and productivity but should be approached with caution in the realm of investing, where the future is inherently unpredictable.

What is the 80/20 rule? Understanding the economic meaning of the Pareto Principle (2024)
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