What is the 80/20 rule? Understanding the economic meaning of the Pareto Principle

  • The 80/20 rule finds that 80% of the effects come from 20% of the causes for any given situation. 
  • The 80/20 rule can apply to a range of fields, but is most commonly used in business and economics.
  • Professionals advise against using the 80/20 rule to guide investing.

If you’ve ever noticed that a few key players in your portfolio seem to be guiding most of its success, you might have been on to something. This idea is known as the 80/20 rule, which states that 80% of a situation’s outputs result from only 20% of inputs. 

Although it’s most commonly applied to business and economics, the 80/20 rule can also be applied to fields like investing and personal finance. Here’s everything you need to know about the 80/20 rule.

What is the 80/20 rule?

Referred to as the Pareto Principle after Italian economist Vilfredo Pareto, the 80/20 rule finds that 80% of the outcomes or results in a given situation stem from only 20% of what went into it. To put it in simpler terms, it means the majority of results come from a minority of causes.  It’s often used to identify the most efficient way of doing things and focus on developing them to maximize productivity.

The 80/20 rule can help individuals either identify and target problem areas and refine current strategies, or understand where a process or input is doing especially well and work to replicate it elsewhere. 

Understanding the 80/20 rule

The 80/20 rule first originated when Pareto observed that 20% of the pea pods in his garden yielded 80% of its peas. He went on to apply the concept on a much broader scale, noting that 20% of Italy’s population owned 80% of its wealth. Since then, the concept has been applied to business strategies, software development, healthcare, and more.

It should be noted that the 80/20 rule is not a strict or definite mathematical law, and is backed by more anecdotal evidence than scientific analysis. It’s mere coincidence that the two numbers add up to 100%, and the inputs (80%) and outputs (20%) are simply meant to represent different units rather than be used to guide precise calculations.

What does the 80/20 rule mean for my portfolio?

Though its applications can be widely observed, investment professionals advise against trying to apply the 80/20 rule when building a portfolio. 

The 80/20 rule can be effectively used to guard against risk when individuals put 80% of their money into safer investments, like savings bonds and CDs, and the remaining 20% into riskier growth stocks. However, using the 80/20 rule to try and hand-pick stocks that will potentially yield 80% of your returns is ill-advised.

“It tells you about history, it doesn’t tell you about the future — nobody knows the future,” says Jill Schlesinger, CBS business analyst and host of Jill on Money. “80% of the people who hit their goals concentrate on their goals, not on their investments.”

In this regard, the 80/20 rule is most relevant as a metric for evaluation, not prediction.

“Upon reflection, you [may be able to] look back and say, ‘You know what, for the forty years that I was an investor, 80% of my returns came from 20% of my portfolio.’ You’re probably not going to know until after the fact, or a period of time, when you can see what that 20% was,” says Schlesinger.

It can also be argued that if only 20% of the investments in an equity portfolio are contributing to 80% of its gains, it’s a rather poor portfolio allocation. 

Generally speaking, each investment in your portfolio should serve a specific purpose and contribute toward the overall goal, whether that’s investing for growth, risk-adjustment, or diversification. Placing too much emphasis on which equities might spur the most growth can distract investors from the bigger picture.

The bottom line

The 80/20 rule finds that most (80%) of a situation or process’s results come from only a few (20%) of its causes. This rule can be applied in a diverse range of fields, but investment professionals advise against using this principle to guide portfolio decisions. 

Instead of using the 80/20 rule to try and curate a portfolio where a few investments will shine, it’s best to establish clear, quantitative investment goals with a diversified portfolio to guard against risk.