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

• The 80/20 rule, also known as the Pareto Principle, finds that 80% of the effects come from 20% of the causes for any given situation.
• The 80/20 rule can apply to a wide range of fields, but is most commonly used in business and economics.
• Professionals advise against using the 80/20 rule to guide investing because it can distract from specific long-term goals.

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. To put it in simpler terms, it means the majority of results come from a minority of causes.

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. Professionals advise against trying to use this rule to actively guide investment strategy, since the stock market can be so unpredictable, but find that it can hold true when evaluating or reflecting on past investments.

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. 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.

Where does the 80/20 rule apply?

• In the business setting: This principle has been used to evaluate and improve management (when 20% of employees produce 80% of results), sales strategies (20% of customers bring in 80% sales) and operations (80% of product defects come from 20% of production problems).
• In personal finance: The 80/20 rule is often used to guide budgeting. It directs individuals to put 20% of their monthly income into savings, whether that's a traditional savings account or a brokerage or retirement account, to ensure that there's enough set aside in the event of financial difficulty, and use the remaining 80% as expendable income.
• In investing: It's been found that 20% of a portfolio's holdings often lead to 80% of its growth. The opposite can also be true, with 80% of investment losses tracing back to 20% of holdings. But because of the stock market's unpredictable nature, this rule is often seen as an effective way to evaluate past investments instead of guide future ones.

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.

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.

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 financial takeaway

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.