Does the 80-20 Rule Still Make Sense?
There’s an old rule that says 80% of an outcome is created by only 20% of inputs. Called the 80/20 rule, or the Pareto Principle, it was created by the Italian economist Vilfredo Pareto more than 100 years ago in relation to the wealth distribution in Italy, stating that 20% of Italians held 80% of the land in the early 20th century.
The rule was later on popularized by Richard Koch in his 1999 book The 80/20 Principle in which he explained that 80% of a company’s business came from 20% of its customers.
In the world of investing and portfolio construction, this rule means that 20% of a portfolio, which includes the most aggressive high-risk assets such as stocks, is responsible for 80% of the return of that portfolio. Meanwhile, the remaining 80% of the portfolio, which is the more conservative part made up of lower-risk assets such as bonds and cash-like instruments, creates only 20% of the wealth.
From a broad perspective, when looking at the stock market, the rule makes sense. If you look at the major stock indices, it’s always a small number of companies, often the largest ones or the ones with the highest valuations, that move the markets and perform the best. The rule implies that stock picking doesn’t have to be as complex as many think. Simply focus on the 20% that delivers. Don’t waste time on the remaining 80%. You’ll save some time and energy.
However, the 80/20 rule isn’t a hard and exact scientific rule built on precise calculations, but rather a general guideline. Investing experts have warned against some of the pitfalls of the rule. Some have argued that 80/20 applies to past investments and returns, but that it’s not always guaranteed that it will apply to future ones.
The main challenge with the 80/20 rule is that it makes portfolio construction look simplistic and almost unnecessary. The goal of portfolio construction isn’t just to pick the investments with the best performing assets that will end up representing only 20% of the portfolio.
Rather, portfolio construction is a much more complex endeavor. It takes into account not only the maximization of expected return but also the appropriate level of risk based on an investor’s profile. It focuses on asset allocation based on an investor’s goals, as well as on the selection of specific investments based on predetermined target weights for each asset class. Every single one of the investments should be helping the portfolio work toward the investor’s goals and have a specific role to play.
While the 80/20 rule may be an entertaining and fascinating concept for some, it has become more of an anecdote in the world of investing and portfolio construction than a hard and fast rule. Rarely referred to by experts and with concrete results still unproven, it might be best to avoid the rule when building your portfolio, and instead focus on tried and true portfolio construction techniques.