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Wednesday, 6 March 2013

The 80/20 rule in investing

The law of the few

Have you heard of the 80/20 rule? The 80/20 rule, also known as Pareto’s Principle or law of the ‘trivial many (80%) and the critical few (20%)’, was named after Vilfredo Pareto, an Italian economist and political sociologist who lived from 1848 to 1923.

This rule states that in many aspects of business and life, 80% of the potential value can be achieved from just 20% of the effort, and that one can spend the remaining 80% of effort for relatively little return.
What could an Italian economist from a century ago have to do with successful investing today?
Vilfredo Pareto noted back in 1906 that some 80% of the land of Italy was owned by just 20% of the population.  He then developed his principle by observing that 20% of the pea pods in his garden contained 80% of the peas.
This observation eventually led to what is now known as the Pareto Principle or more commonly, the ‘law of the few’ or the 80/20 Rule: that 80% of the effects or outputs are often derived from 20% of the causes or inputs.
All fields of life

The 80/20 Rule is a gem of a principle because it appears to occur in so many fields of life.

In business? You might find that 80% of your sales (and complaints!) are derived from 20% of your customers.

80% of your company sales are made by 20% of the sales team. 

20% of your efforts produce 80% of the results.

In health and safety? Do 20% of the hazards that cause 80% of the injuries or accidents?

20% of your activities will account for 80% of your success.
In customer service? Microsoft found that by fixing the top 20% of the most reported bugs, 80% of the errors and crashes could be eliminated.

Wealth? Does just 20% of the population hold 80% of the wealth of a nation? Often. The same applies to the wealth of the world.  The law of the few even seems to apply to subsets of the income range: the world’s richest 3 men own as much as the next 7 put together.
The implication of all this? Focus on getting the big decisions right.
How do we apply this to investment?
Warren Buffett once said that we don’t need to make too many great decisions; we just need to limit the quantum and the magnitude of the bad ones.
Another way of saying this is that if we lose too much we can’t win overall. This is well demonstrated in the table below:
% asset falls in value
% recovery to break even
Impossible to recover

If an asset falls in value to zero, it is worthless: it can never recover. The implication of the table above is to seek assets with which show proven growth over the long term, and leave the speculative vehicles to the speculators.
Less can be more…
The best property investors are often those who make fewer decisions. What do I mean by that?
Well, the most successful investors I have seen are very often those who have bought and held on to prime location properties over a long period of time, rather than those who are constantly buying and selling in order to time the market.
The high transaction costs and the effect of capital gains tax ensure that high-frequency trading is usually an impractical approach to property investment.
Remember that 80% of your outputs are likely to come from 20% of your inputs.
Successful property investors should therefore concentrate on making fewer but bigger decisions. Due to the use of leverage, property investors can often make a huge difference to their net worth even by only acquiring a handful of assets.
It’s all about the power of focus.

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