How often have you been sitting in front of your phone, staring at your portfolio, wondering where it all went wrong? After all, your investment strategy (following advice from teenagers on Twitter and TikTok) was foolproof, right? Have you ever wondered if there is a hard and fast rule that can help you allocate your funds and weigh your investments in a structured manner, especially during turgid economic conditions? (Crisis investing is a skill in and of itself.)
Lucky for you, one does exist. A famous principle called the Pareto Principle, or the 80/20 rule, has largely been used as a framework of return as compared to one’s investments and as a general framework for asset/input allocation.
This article will:
- Explain the concept
- Explain it from an investment perspective (including retirement planning)
- Explain it from a personal/industry agnostic perspective
- Provide possible drawbacks and warnings regarding the concept
80/20 Rule (the Pareto Principle)
The 80/20 rule, named after Italian economist Vilfredo Pareto, guides long-term investment decisions, among other uses.
According to this principle, roughly 80% of your investment returns will come from just 20% of your investments/asset allocations. This means that a relatively small number of high-quality investments can provide the bulk of your investment returns, while the majority of your investments may provide relatively modest returns or even losses.
Image by: Asana
As far as a useful guideline for investors looking to improve their portfolios goes, it’s pretty good.
By concentrating on the few investments that are likely to provide the highest returns, investors can potentially achieve better overall results and reduce their risk of losses.
Yes, this means that your days of having a “diversified” portfolio of just riskier growth stocks are over. Mix in some blue chip stocks; it won’t hurt.
The 80/20 Rule in Practice
Think of this example: you can have a diversified portfolio consisting of different asset classes, investments (yes, you can invest in a recession—we can show you how), and financial vehicles, all meticulously put together to produce the most returns in the most efficient way. However, you notice that your small little commercial property is seemingly a cash cow. In fact, this business accounts for around 80% of your capital gains despite being a very small portion (about 20%) of your overall investments.
The 80/20 Investment Strategy, an example
Let’s explore the 80/20 rule in the context of an investment scenario.
Let’s say you have a portfolio of 10 stocks (don’t worry, even in this market, we can help you invest), and you invested $10,000 in each stock for a total investment of $100,000. Over the course of a year, your portfolio generated a total return of 20%, or $20,000.
You take a look and notice that Companies A and B provided returns of $10,000 and $6,000, respectively. So, out of the $20,000 return, two companies (20% of your allocation) accounted for $16,000, or about 80%.
As far as rules go, it is important to remember that while the 80/20 rule can be a useful guideline, it may not work for all investment profiles and asset classes. Factors such as market fluctuations, inflation, and other assorted risk(s) can impact the outcomes of said investments.
It’s essential to approach each investment decision with careful consideration and a well-informed strategy (copying trades from the guy that livestreams on TikTok is not a finance strategy).
80/20 Rule for Long-Term Financial Goals & Retirement Planning
I am no financial advisor or personal finance guru (I promise not to try to sell you on some course), but I do know the 80/20 rule can be used to strategize retirement savings and build a diverse portfolio.
How can you use the 80/20 rule to reach your investment goals? A few techniques are:
- Investing 80% of your funds in retirement accounts and the leftover 20% into high-yield securities (think: savings bonds).
- Invest 80% of your
moneyin passive index funds, leaving the remaining 20% in real estate.
- Invest the majority of your holdings in real estate and the lesser 20% into the before-mentioned bonds.
Image by: Macleans
- Invest 80% of your investable income in blue-chip company stocks (yes, I know, it’s boring) and 20% in small and midcap stocks (you’re going to want non-cyclical stocks; we can explain).
The 80/20 rule can be configured in any way in terms of asset allocation, depending on your goals, the market, risk tolerance, your vision for the future, etc.
The 80/20 Rule: For You
Not to worry, for you well-rounded readers, this concept is applicable in all industries where quality management is of the utmost importance (so pretty much all of them). That is to say, where the idea is to reduce and/or mitigate production problems, product defects, and things of that nature.
In fact, this 80/20 rule (which is the same as “vital few and trivial many”) is applied in a gamut of different fields. These include business management, economics, project management, and even for personal productivity (planning for future success, auditing spending habits and expenses, budgeting, etc.).
The idea behind the 80/20 rule in your personal life is that 80% of your results will be from 20% of your efforts. If you spend your time and focus effort on the vital (see, it’s starting to come together) few actions that maximize value, from a personal perspective, you will be able to maximize productivity and achieve the best results.
An example (in case you still need some help)
Realistically, how can someone achieve maximum value using the 80/20 rule?
For example, let’s say you have a big project due in two weeks (and you aren’t procrastinating). Instead of trying to focus on granular tasks and details, you can use the 80/20 rule to identify the most important factors that will help you complete this completely-not-made-up project on time.
This may involve focusing on the 20% of tasks that contribute to 80% of the project’s success, such as outlining the project, researching key information, and creating an effective structure for the final deliverable. Sourcing images and media may have to take a back burner.
Furthermore, as we all know, everyone has unique needs and priorities. Therefore, you can adapt the 80/20 rule to fit your specific circumstances and goals; think of it as a template or framework.
All in all, by utilizing this rule for personal productivity, you can effectively prioritize your efforts, achieve better results, and focus on what really matters to achieve your bigger-picture goals.
Possible Drawbacks of the 80/20 Rule
The 80/20 rule is a proven method that helps people save
However, the 80/20 rule does have some drawbacks and warnings, which I will (graciously) outline for you:
- Limited applicability (not everything can be evaluated using this framework)
- It can be hard to identify the “vital few” and harder still to find the “trivial many”
- Systems tend to be dynamic; the 80/20 rule treats them as static
The Point of The Rule
The point is, frameworks such as the 80/20 rule are useful tools that help you conceptualize and structure the path to a desired end. It is a quasi-scientific analysis for the unscientific across disciplines and industries. However, when using such a framework, you must not become inflexible and rigid. You must allow bend and be dynamic in knowing when to utilize it and when not to, but as far as rules go…this one is pretty good.