Expanding the 80-20 Rule to Alternative Investments
We often think that the more effort, money, or time that we put into something, the greater the returns we will see. But, input and results rarely correlate in such a straightforward way.
More often than not, input and outcome seem to follow the so-called “80-20 rule.”
What is the 80-20 Rule?
Originally called the Pareto Principle, the 80-20 rule originated in the late 1800s when an Italian economist and amateur gardener named Vilfredo Pareto found that most of his garden’s yield was produced by only a few of his plants. In short, those that overproduced the most made up for those that didn’t produce as much.
This concept was later popularized anew by the 1999 book, “The 80-20 Principle,” by Richard Koch, in which he applied the principle to modern business, describing how many companies generate 80% of their business from 20% of their customers. On the same token, 20% of employees produce 80% of the work… 20% percent of your efforts produce 80% of the returns… and on and on.
The 80-20 principle can also apply to investing, guiding investors on how to diversify risk, increase returns, and more by focusing their attention and capital on the most productive assets in their portfolio. But it’s not just all about stocks and bonds. The principle can just as well be used to guide investment in alternatives and other asset classes.
Here’s how to use the 80-20 rule to develop your investment strategy when it includes alternative investments.
Diversifying Risk and Increasing Returns
When applied to an investment strategy, the 80-20 rule guides investors to build their portfolios with assets that are 80% stable and 20% growth-oriented. Predictable investments include U.S. Department of Treasury bonds, index funds, and other investments that have minimal growth opportunity and minimal risk.
More recently, investments in alternative asset classes are being used to hedge against risk and inflation. The art market, a growing alternative to securities, saw an average gain of 10.6% in 2018. After the first 80%, the remaining 20% can be placed in high-stakes investments, which are high-risk but also allow for the possibility of bigger returns. By placing 20% of your investments in high-stakes assets, you create the opportunity for a bigger pay-off while protecting the majority of your assets.
Developing an Investment Strategy
The Pareto Principle goes beyond helping to determine how investors allocate their money. It also helps to describe how they should use the less quantifiable asset of time, specifically that spent researching investments.
According to the principle, 20% of the time that investors spend researching usually generates 80% of the most useful information. To minimize and more effectively research, you should identify your specific research goals in advance of your assessment for both traditional and alternative assets. Art, specifically, requires thorough research for those new to the art market.
Applying the 80-20 rule in real life is less cut and dry than it is on paper. To help, try visualizing your portfolio. On a piece of blank paper, draw two circles, one inside the other. In the larger circle, identify your safe or stable investments. In the smaller circle, identify your high growth/high-risk investments. If you find that too many investments seem to sit around the perimeter of the small circle, perhaps it’s time to include more risk in your portfolio. Similarly, if the smaller circle seems to burst into the larger, empty low-risk circle, perhaps it’s time to make a few safer investments.
Not much in life is black and white, but whether you lose or grow money is less than gray. Remember, however, that not every investment has to win big to be successful— instead, only a few do.
Ready to add a true alternative investment to your portfolio? Masterworks is making it easier than ever to invest in blue-chip art, allowing everyday investors to tap into the incredible growth potential of this uncorrelated alternative asset.