Tuesday, January 29, 2008

The 80/20 Rule - Let Pareto Do Most of the Work

The 80/20 percent principle has been one of my favorites for a long time. Most of us have derived this rule intuitively through our experience but are not aware of its full potential.

Applying this principle or rule will help you to instantly separate the wheat from the chaff and focus your efforts to gain the maximum desired effect with minimum investment.

In my university years I found out I was doing quite well with out too much effort. I did not excel but also did not wish to sacrifice my spare time studying for those extra 10 points. We are all familiar how 20% of studying yields 80% of the grade. You have to invest 5 times more to get a whopping 100. Is it worth it?

The 80/20 principle also applies in many other cases. As examples consider the following:
1. 20% of clients always seem to generate 80% of revenues
2. 20% of the population usually owns more then 80% of the wealth
3. 20% of taxpayers usually pay more then 80% of total taxes
4. 20% of blog posts usually draw 80% of traffic
5. 20% of products generate over 80% of revenues
6. 20% of code uses up 80% of processing time
7. We wear 20% of our clothes 80% of the time
8. 20% of time generates 80% of the work

In short, 80% of the effects comes from 20% of the causes. This effect or rule is named after Vilfredo Parteo, an Italian economist, who noticed 80% of income in Italy went to 20% of the population.

Being aware of this phenomenon or rule and applying it to analytical situations will often yield very benefiting results. In advertising you will probably notice 80% of the impact comes from 20% of media. These sort of analysis is another tool for your tool box to help you concentrate you efforts where they should be concentrated relatively fast even if it is a bit 'quick and dirty'.

Applying the 80/20 principle to investing dictates 20% of investment yield 80% of the return. The result is actually not intuitive and quite risky. We should avoid diversifying and invest our money and effort in the correct 20% of the portfolio and then "watch it like a hawk". This conclusion is probably right but is very risky and requires more knowledge and resources then most investors have at their disposal.

A good book which elaborates more on the 80/20 principle and its application is "The 80/20 Principle: The Secret to Success by Achieving More With Less" by Richard Koch (Sponsored Amazon link).

Image by Kaufmajn

No comments: