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.
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?
