Thursday, March 19, 2015

The Pareto Principle (80/20) Investing Strategy

In 1906, Italian economist Vilfredo Pareto created a mathematical formula to describe the unequal distribution of wealth in his country, observing that twenty percent of the people owned eighty percent of the wealth. The 80/20 rule has then been commonly used throughout everyday's life to assume the practical meaning of 20 percent that are vital and 80 percent that are trivial.




I am a firm believer of the idea behind this principle, including investing. I believe that the investment I made at present day will compound over time to give the majority of the results in the future. This is very powerful because you are essentially spending time today to train and dedicate the golden goose that will yield you an unimaginable superior results in the future.

The same goes for Warren Buffett for instance. Since the inception of Berkshire Hathaway in the 1950s, the company has delivered outstanding long term results for its shareholders. The management eye for detailed investment in American Express and Coca Cola in the early years have delivered over $20 billions in capital gains and dividends and until today they are still holding on to these great companies. Being just a normal human being, the man has made some mistakes too along the way such as the Tesco investment which he admitted he did but it should not be seen as an isolation. The point being in the preceding 30 to 40 years, Warren and Charlie compounded their great wealth of knowledge and eye for investment in great businesses that made up 20 percent of what is really important that yields 80 percent (majority) of the results. That is all that is important to him and his shareholders.

I have previously written an article (original article here) on one of Warren's favorite quotes which sparked several debates in the comments section. I thought it was a good time to revisit that a little bit. Personally, I feel that it is a brilliant mental framework for every investors to consider, even if the strategy does not fit our own investment profile. In the analogy, he referred an investment selection as tickets which an investor has only 20 chances to make throughout his lifetime and because of the limited selection, this prompt investors to think much more deeper about the investment they made than under the normal circumstances.

At the moment, I do not have the experience of a decade-termed investor but I believe that in a typical investors career, out of the 80 -100 investments they have made, probably less than 20 or about would end up accounting for the majority of the investment gains. These are termed as "winners" in yours and my portfolio. In one of his book, Warren once said that as investors, we are not paid for the number of activity we did but rather we get paid for being right. In other words, an investor could spend his whole day watching the news, participating in forums, increasing the number of buying and selling activities and still the efforts do not account for majority of the gains.

This is the Pareto Principle we are talking about - 20 percent focusing on the right amount of effort on the right companies that yield 80 percent of the results.




As an investor myself with a focused investing strategy on dividends, the important thing is to focus and uncover quality dividend paying companies with strong cash flow generation with staying power. Companies with these attributes usually tend to have an above average performance and they tend to earn and increase their dividends payout over time, yielding investors increasing cash flow for many years to come. In fact, these few investments are all we need as an investor in our lifetime as they will do the heavy lifting for our portfolio that will outperform the general market.

The Pareto Principle is the law of vital few and a measure of productivity. We should be looking at implenting the principle in our everday's lives, even if they are not being applied solely to investing. The next time you are trying to do something, think of the Pareto Principle and see if the 80/20 rule works for you.

What do you think of the Pareto Principle? Does it applies to investing or other activities in your life?

27 comments:

  1. Hi B,

    The problem I have with this Pareto principle is that you have no idea which is the 20% to focus on that will generate 80% of the results, until it had happened. Let's suspend judgement first on why it must be 20/80 and not 30/70 or any other ratio. Suppose that we have 10 class mates and you're supposed to network with 8 of them (80%), so that next time when they are the super wealthy, you can benefit from their network too. How do we choose which are the 20% that will be hold 80% of the wealth of all the 10 classmates?

    To me, this is an unactionable advise. Logically sounding, but impractical. And to this, I have another unactionable advise: Put 100% of your money on the winners, hold the stocks before it becomes a loser and soon you'll be wealthy.

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    1. Hi LP

      First of all, many thanks for your constructive debate. I think what differentiates our blogosphere from the many outside there is that many of us always had different opinions that looks from a different angle point of view which makes an interesting train of thoughts for discussion.

      I think the differences between the thoughts is through looking at the principle not as a means to an end but rather the end itself. I agree that many times, the 80% trivial matters that we do are things or actions that we need to discover or trial and error such that there is no way we can do without it and simply focus straight onto the 20% important matters directly. This goes for things such as selection of stocks where we are constantly finding a means to an end, justifying our reasons that supports our investment thesis. These actions do not yield the important results we want but is a process in order to yield a better results.

      The same goes if we take a case for the employee, say myself. As an employee myself, everyday is a means to an end of completing the necessary work by the end of the day. This doesn't mean that I don't have to do the trival matters that require printing, scanning or reconciling for that matters but this is a step that supports the end results, the KPI objective that I am given to by my managers. Now, I can choose to keep focusing on these unimportant never ending emails or i can choose to focus straight on what is important to me and to the company, maybe say revenue recognition which directly impacts the PnL of the company. I'm pretty sure the management wants to see me concentrating on the latter rather than the former because time is limited and capacity is constrained.

      At the end of the day, I think this just means to sound logical and to put focus on things that matter more to us than not since our capacity is constrained in some way. That’s just what I thought it is and maybe it’s different from what you or Pareto sees in this.

      Delete
  2. Hi LP

    Those are great thoughts there because I seldom come across arguments against pareto principle. One point I can think of is that the principle only can be put to use when you have some data to peruse eg you can tell which stocks are making money for you after 1 year or which friends are benefitting your network after a few months. Then only you apply the principle to focus more on the winning stocks /friends. Without this data, the principle is not of much use. In that respect, it's not meant to be applied on a forward looking basis.

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    1. Hi RetailTrader

      Yeah, as my explanation to LP above, looking it as a means to an end means that you probably can only see this as a backtrack rather than forward looking.

      I think if we are looking it from another angle, we can see the principle as forward looking.

      Delete
  3. Hi RT,

    Haha, as a gentle poke, then how long do we wait until we see the 'actual' results? ;) If Vilfredo Pareto actually carried out his findings on wealth on the general population within 1 year of work time, I'm quite sure the results will not be immortalised in this principle we're debating about in the first place!

    In general, I'm in agreement with the principle - it's just that it isn't very useful for people to apply it. I'm in total disagreement with how the Pareto principle is used to advise pple as a sort of forward looking plan. Like you, I think the principle should be used to deconstruct things instead. I'll give a few examples:

    1) In an essay, 80% of the main points are found in 20% of the content. Your job is to weed out 80% of the content to distill out 80% of the main points.

    2) 80% of your gains are found in 20% of your watch list. Your job is to clear out 80% of your watchlist to distill out 80% of your potential gains.

    3) In your network of friends, 80% of your next business comes from 20% of your contacts. Your job is to weed out 80% of your contacts in order to extract out 80% of the next business.

    Concentrating on the 20% to get the important 80% of the results might sound the same as removing 80% of the nonsense to get 20% of the gem, but it’s not really. The former suggests doing very few but important things, whose significance is not known until it had happened. The latter suggests doing a lot of potentially redundant work (go out to meet everybody but shortlist 20% of them, research a lot of companies but shortlist 20% of them, reading a lot of books but retaining 20% of them etc) all for the purpose of removing a bulk of them. Redundancy anyone?

    For that, I must disagree with Buffett when he said that we are not paid for the activities we do but we get paid for being right. I think all the 80% of the activities that we do but didn't get paid is because we are training ourselves in order to recognize the 20% of the activities that do constitute 80% of the our pay ;)

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    1. LP,

      On last para, u disagreeing with the idols of many... u do not know how to spell die..

      But I like it..

      Delete
  4. Hi all,

    Interesting discussion here. I see the Pareto Principle as an observation and a guideline. One does not have to be obsessed with the numbers (80/20) but simply assimilate the concept.

    For a lazy person like me, it reminds me to only focus on what is important in my life and skip the rest.

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    1. Hi SRSI

      I have the same thoughts I want to put across here.

      I think it's just a quick logical guide, similar to saying that studying will score you better As than not studying, though we sometimes do see cases where students who didn't study score better results than students who did not. Just something along that line.

      The number itself can be whatever percentage, 70/30 or 90/10. It doesn't matter in the end.

      Delete
  5. In layman retail investors term, hold on to our winning stocks that still are providing XX% Yield on cost and re-invested the rest to keep finding newer ones, at the end of several decades in the market of bulls and bears when we look back at the portfolio performance. We may say "Yeap. Pareto Principle does apply to Investing"

    So it is backward looking but we are looking forward to make it truth as our own investing principle.

    :-)

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    1. Hi Uncle CW

      Applying the Pareto Principle to investing directly is a little tricky because you never know how the stocks is going to perform until the results prove itself. But it is the action that investors can take and should be focusing on which many choose to ignore.

      Delete
    2. last month I finished reading "fooled by randomness" book.. here is something the author will disagree with most of us..

      historical data and frequency of probability has no relevance to future results.

      Delete
  6. Hi B,

    I am reading a book on habits and it is somewhat similar to the 80/20 rule. The biggest change is not by doing many things but from something small and somewhat insignificant. There was this case study of how a lady who underwent a total transformation from a failed relationship and near bankruptcy. What caused the change wasn't because she stopped smoking, mended her broken heart, went to seek help etc but because she went for a walk. This walk was the beginning of a small habit which led to the accumulation of many other good habits which transformed her life. There was also another example of how the simple action of making your bed everyday can lead to major transformations.

    But of course like what LP has pointed out, the key is what habits to start and there is another lengthy chapter which I am still reading.

    Cheers!
    Derek

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    1. Hi Derek

      Thanks for sharing.

      There is a difference here between doing something that is trival but important and doing something that is trivial but not important. I think the case you've described demonstrates the latter while Pareto was talking mostly about the former I believe.

      Delete
  7. Hi,

    The principle is more an outcome not a strategy.

    The principle in much simpler terms is to have Priorities. Your top few priorities often has much greater impact than the rest.

    In life n work this applies... not really in investment..

    @Investment
    this principle applies, but it is an outcome. It cannot be use as a strategy.

    Since every investment before u press the buy button is ur top priority. If u have 5 stocks, u cannot say my priority is only 1 or 2 out of the rest.

    I guess that maybe what B is trying to say is now he is only focusing on few stocks only with higher amt vested in each stock. And this is good enough for him getting good rtn.

    but if 20/80 strategy applies... then out of ur 10 stocks, only 2 will give u good money. then how sure are u that it will comes from ur top holdings?

    @In Life
    This applies.. see my blog post on priority.

    http://www.rolfsuey.com/2015/01/what-is-your-first-priority-liam-neeson.html?m=1

    @In Work,
    This applies... I agree with B that many things u need to do in work, only few impt ones matter... but u also cannot NOT do the small trivial things.

    This is easy, always do the most impt things first thing in the morning..

    What I want to add is work performance KPI is not all only impt if u want to progress in work. only 1/3 done. 1/3 Luck + 1/3 relationships n being likable n well connected. Esp in a bigger co setup.. Mnc


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    1. Hi Rolf

      Actually what I meant was something more than just the return itself. It is bigger than that. Return is a measurable factor which is important but there are things more important than that. Regardless of whether the stock we choose make the desired return at the end of the day, as long as the actions leading to that justify, there is plenty of learning points to take home and I am satisfied by it.

      Delete
    2. Hi B,

      Apologies for the misunderstanding because I read above post is about investment. And my meaning of "return" means "good outcome" out of the investment. so perhaps my meaning of return may also include the bigger things or more important things than that including learning, experiences.. etc. :)

      Anyway, I think this is one very good topic for the reader to think intensively.

      To be able to brainstorm and write an article and invite all the comments is so many times greater than me just commenting.

      It is so easy to give comments, sometimes poke.. but then again simetimes we ask ourselves, are we able to write a detail article as what u have done or at least r we putting the effort u put in on that.

      So overall it's nothing but admiration for me out of this article.

      SMOL - please take note! Hahhaa :p.
      this is 100x better article than just a picture!

      Delete
    3. Rolf,

      Wow! That's a quick capitulation or what? Write a long comment; one short comment by B and we see apologies flowing out like Merlion...

      Hee hee. Must discount what you say next time. Your grand edifice have no foundations....

      LOL!

      See? Next time you try to use this trick of changing the subject choose another target.

      Just because you can't appreciate a picture is worth a thousand words doesn't mean others can't ;)

      The more you talk; the deeper you put your foot in your mouth. You poor thing...


      Delete
    4. B,

      Good article.

      Even greater at holding your ground and not letting others blow you off course.

      Thumbs up!

      We'll meet on the 30th. Let's have fun!

      Delete
    5. Hi SMOL,

      Oops... the lao jiao is talking now.. not coughing anymore! Sh$@@t.. should not challenge Lao Jiao. sure have hard time.. now got it...

      LOL

      There is a diff bet being polite and capitulation!

      Apologies was for only the part on "return" !Naturally I thought investment is just for "getting return" in layman terms, but B explain its more than that. Hmmm...it's so abstract.. so this is the misunderstanding that need apologies from me.

      Ultimately I did not divert the "essence" of my initial comments "outcome vs strategy!" Hey my foot is still on the ground. With strong piling!

      Maybe I learnt something over the years.. even if we strongly believe in something, it may not be most meaningful trying to get into a debate that can have temperature rising. 以和为贵!

      But hor now u say I am a poor thing :(
      Personal attack.. I must fend and explain myself.

      If it were 7-8 yrs ago. Haha..different different me... hot n heated. Personal attack back.. My belief now is still the same but maybe approach is different - softer! Feel it?

      *Handshake and friendly headbut*
      I present u the most radiance smile now :-)

      Btw... wats is on 30th? Can "poor thing" participate?

      Delete
    6. Hahahaha. SMOL and Rolf are classic. We should get together on the 30th and have a glass of drink to settle this one out.

      Rolf, theres an event of gathering on the 30th but think tickets are already sold out.

      Delete
  8. I think in investing the 20/80 rule should be used like eg 20 small caps / 80 blue chip. We definitely want our investment to be successful

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    1. Hi Jimmy

      These days when I think of.noble goldenagri and wilmar, I really think they have become a black chip. Beaten until.no one wants them anymore. Lol

      Delete
  9. Someone wise once told me, you work smart, not work hard. A smart person have a plan before he/she proceeds to do the job. Therefore, he'll spend less effort and time to achieve the goal, than the one who do the job without a good plan.

    I apply this at my work many times. I saved my department $1-2 millions when I see they have higher earner doing a mindless job, repeatedly inefficient way. I made a spreadsheet that cut down their time from45 minutes to less than 5 minutes.

    I wish I'd get on the dividend path sooner, when you almost break no sweat, buying solid companies, and get consistent payout every quarter, and dividend increase every year. That's is zero to nothing effort and 100% reward. :)

    I just love you bring up these good lessons on your blog consistently, I'll have it on my next weekend read post. Thanks for sharing.

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    1. Hi Vivianne

      Many thanks for your kind words.

      I have the same mentality about doing things effectively at work, which is why I advocate productivity very much and like things to be done in a subtle manner. I just feel that companies are wasting way too much resources on unimportant reports that does not bring much value to them.

      Delete
  10. Last time when I was still in the corporate world, one of my bosses told me about the Pareto Principle and told me to work smart.

    Being young and rash and full of gusto, I thought " Pareto bullshit la ...I can work hard, work smart, ball harder!"

    After I started my business, I started working 7 days a week. (Even when I was working, I was working 6 days a week, more than 12 hrs a day.) I thought I was damn tough. Soon, I started realising, that my business was running me, not me running my business.

    Although, I don't specifically go and try to quantify my work into 80/20 denominations, by keeping in mind the Pareto Principle, I force myself to eliminate unproductive and unimportant work. It's been working well.... for now.......

    Whether it works for my portfolio, I can't tell yet! Gotta check back 10 years later!

    Great Post!

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    1. Hi BfGf

      Thanks for sharing your experience.

      I think many times people do realize it though unconsciously we are doing the opposite for whatever reason. It's definitely not as straightforward as the principle suggests but keeping in mind the bigger picture, the essence is to remove the excess and keep the rest.

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