The 80/20 Rule

I'm sure you might have heard the term, "80/20" in your days browsing blogs, reading articles and watching the news. Usually, the 80/20 rule is used when people are talking about employees at companies - what they imply is that 20% of the employees produce 80% of the revenue, and that the other 80% only account for 20% of the revenue. It makes most people think that obviously, the company should just fire that 80%! And to an extent that's true... but there's a certain dynamic that is missed out on in such a simple explanation of the rule. The rule is also not very talked-about much when it comes to money. That's why I chose this topic today for MoneyBrick!

Let's look at it simply first: some people say that 20% of their stock portfolio is giving them 80% of the gains that they received this year. The other 80% only gave them 20%! Isn't it time to get rid of that other 80%? It might seem like an obvious answer, but the real answer is no. Although you can identify precisely in your portfolio which stocks accounted for the majority of gain - unlike a company that may have a harder time identifying the top producers - you may screw yourself over the next year! The catch is that although this year stock ABC and stock CBC gave you 80% of your returns; there's an equal likeness that next year, they will be the under-performers (relatively speaking, of course). If you choose your stocks well, all of them will go up, but some will undoubtedly outperform all the rest.

Even though people like to slap labels on certain statistical discoveries and call them things; "80/20 rule", "law of the few", etc. The fact is that these observations are always in hindsight and thus very clear. It's easy to discern a pattern when you're looking for a pattern through historical performance. Just as it's easy to see various animals in random cloud patterns! Basically, it would be close to impossible to pare down your investments so that all your holdings are giving you a phenomenal rate of return. It's probably a lot easier to pare down a company - to get rid of people who don't do their job well - but there's also an intermingling between the "20" and the "80" that in part account for how a smaller number can produce a majority of revenue, results, etc.

When it comes to anything, it is usually the entire mix of what you have in your basket that produce the results that you get. Surely, you can break it all down and say that this and that produced 80% of the results, but it is possible and more than likely that whatever little seemed to produce those large results were assisted in unseen ways by everything else. No one would argue that flour is really important in baking a loaf of bread - but flour makes up such a large portion of the bread and without yeast, it's nothing. Does that mean one should try all manner to get rid of the flour, because yeast does so much for so little? You see... not really! The truth of the matter is that bread requires both huge amounts of flour and a little bit of yeast; they work best that way and although seemingly put forth differing amounts of effort - it is only together that they can produce the desired result.

So basically, when it comes to money, education, business or anything else that's important to you, don't take the 80/20 rule to an extreme and start cutting out what's big and seems to not be doing its job. You might find out that it was the interaction between the various ingredients that was the most important after all.