The 80/20 rule has the power to explain your investment returns
Principle states that 80 per cent of the results come from 20 per cent of efforts.
It is widely observed that"
- For a trader- 80 per cent of the profits are generated by 20 per cent of trades.
- For a business- 80 per cent of the revenue is generated by 20 per cent of the customers.
- For a student- 80 per cent of the exam result is the effect of 20 per cent of the effort.
- For a country – 80 per cent of the wealth is held by 20 per cent of the population and likewise,
- For an investor- 80 per cent of the returns are generated by 20 per cent of the stocks in the portfolio.
80/20 rule or the Pareto Principle was coined by Italian economist Vilfredo Pareto. Pareto had observed that 20 per cent of the pea pods in his garden were responsible for 80 per cent of the peas. Amused by the observation, Pareto expanded this principle to macroeconomics by showing that 80 per cent of the wealth in Italy was owned by 20 per cent of the population.
How does Pareto Principle apply to your portfolio?
It is no secret that the Big Bull of the Indian stock market, the late Rakesh Jhunjhunwala accumulated 80 per cent wealth from investment in stocks like Titan and Escorts.
The message – Allocation matters
20 per cent of your investment will dominate (80 per cent or so) of your portfolio returns. However, it is wise to appreciate at this point that the exact proportion does not hold true always. The idea is to appreciate the strong inverse relationship.
An investor should analyse the source of 80 per cent of his wealth which can be around 20 per cent of all the investments and he should focus on those identified assets. Future investments can be made in those assets.
By doing so, the investor essentially puts his time and money into the most important and rewarding positions.
Have you checked your portfolio to find the source of 80 per cent returns?