80–20 Rule - Meaning and Benefits in Investing (2024)

The 80-20 rule, also known as the Pareto Principle, states that 80% of the outcomes (or outputs) come from 20% of the causes (or inputs). This principle isn't limited to just business or economics; it can be applied to many areas of life. For example, in wealth distribution, a small percentage of people often hold a large portion of the wealth. Similarly, in personal finance and spending habits, a small portion of your expenses might account for most of your spending. Even in personal relationships, you might find that a few of your relationships contribute most to your overall happiness.

In this article, we will explain the 80-20 rule and how it works. We will look at its history and the benefits it offers. We'll also provide real-life examples to show how it can be used in practice, especially in investment strategies and mutual funds. Moreover, you will understand how this rule can help you identify key assets and improve portfolio performance.

What is the 80-20 rule?

The 80-20 rule, also known as the Pareto Principle, suggests that 80% of results (or outputs) come from 20% of causes (or inputs) for any given event. This rule is widely applied in businesses, where its primary goal is to identify the most productive inputs.

When managers apply the 80-20 rule in their work routine, they can focus on the most important tasks or factors that contribute most to their success. For example, if a manager identifies the top 20% of customers who generate 80% of the company's revenue, they should prioritise serving and retaining those customers.

It is worth mentioning that while the 80-20 rule is commonly used in business and economics, it can also be applied to other areas. Some common examples include wealth distribution, personal finance, spending habits, and personal relationships.

How does the 80-20 rule work?

The 80-20 rule can be applied to various aspects of life, such as business, productivity, health, and relationships. For example, 80% of your sales may come from 20% of your customers, or 80% of your happiness may come from 20% of your activities. The key is to identify the 20% that matters the most and focus on them.

How does the 80-20 rule work in mutual funds?

Similarly, the 80-20 rule can be applied to investing in mutual funds. Mutual funds are pooled investments that invest in a variety of securities, such as stocks, bonds, commodities, etc. They offer diversification, professional management, and convenience to investors. However, not all mutual funds are created equal. Some may perform better than others or suit your goals and risk profile better than others. Therefore, it is important to find the 20% of mutual funds that can deliver 80% of your desired returns.

Example of the 80-20 rule

Ananya, a student at IIM Bangalore, was excited about her digital marketing course assignment to create a blog. She put a lot of effort into designing and writing content. However, during the mid-term evaluation, she was disappointed to find that her blog had the least visitors compared to the blogs of her classmates.

Determined to improve, Ananya decided to use the 80-20 rule. She carefully reviewed her blog and found that 20% of its content was the most interesting to readers. She also identified the best ways to promote her blog. Ananya focused her time and energy on improving this top content and employing effective promotion methods.

Because of this, her blog's traffic grew, showing how useful the 80-20 rule can be for improving performance.

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Importance of the 80-20 rule in investments

The 80-20 rule can help you achieve several benefits in your investments, such as:

• Simplifying your portfolio: By applying the 80-20 rule, you can reduce the number of mutual funds in your portfolio and focus on the ones that have the highest potential. This can save you time, money, and effort in managing your investments. It can also help you avoid over-diversification, which can dilute your returns and increase your costs.
• Enhancing your returns: By applying the 80-20 rule, you can allocate more of your capital to the mutual funds that have the best performance and prospects. This can help you maximise your returns and compound your wealth over time. It can also help you avoid under-performing or risky mutual funds that can drag down your portfolio.
• Aligning your investments with your goals: By applying the 80-20 rule, you canselect the mutual funds that match your investment objectives, time horizon, and risk tolerance. This can help you achieve your financial goals faster and more efficiently. It can also help you avoid emotional or impulsive decisions that can harm your investments.

How to implement the 80-20 rule in different scenarios?

The 80-20 rule is not a one-size-fits-all formula. It can vary depending on your personal situation and preferences. Here are some examples of how you can implement the 80-20 rule in varying situations:

• Scenario 1: You are a young and aggressive investor who wants to grow your wealth in the long term. You have a high risk appetite and can tolerate market fluctuations. You can apply the 80-20 rule by investing 80% of your portfolio in equity mutual funds that have a track record of delivering high returns, and 20% in debt mutual funds that can provide stability and income.
• Scenario 2: You are a middle-aged and moderate investor who wants to balance your growth and income. You have a medium risk appetite and can tolerate moderate market fluctuations. You can apply the 80-20 rule by investing 80% of your portfolio in hybrid mutual funds that invest in a mix of equity and debt securities, and 20%inliquid mutual funds that can provide liquidity and safety.
• Scenario 3: You are an elderly and conservative investor who wants to preserve your wealth and generate income. You have a low risk appetite and cannot tolerate market fluctuations. You can apply the 80-20 rule by investing 80% of your portfolio indebt mutual funds that invest in high-quality and low-duration securities, and 20% in equity mutual funds that can provide some growth and diversification.

Common ways of using the 80-20 rule for investments

• By asset class: You can use the 80-20 rule to allocate your portfolio between different asset classes, such as equity, debt, gold, etc. For example, you can invest 80% in equity and 20% in debt, or 80% in debt and 20% in gold, depending on your risk-return profile.
• By fund category: You can use the 80-20 rule to allocate your portfolio between different fund categories, such as large-cap, mid-cap, small-cap, sectoral, thematic, etc. For example, you can invest 80% in large-cap funds and 20% in mid-cap funds, or 80%in sectoral funds and 20% in thematic funds, depending on your growth potential and diversification needs.
• By fund performance: You can use the 80-20 rule to allocate your portfolio between different fund performance, such as top-performing, average-performing, and bottom-performing funds. For example, you can invest 80% in top-performing funds and 20% in average-performing funds, or 80% in average-performing funds and 20% in bottom-performing funds, depending on your return expectations and risk appetite.

How the 80/20 rule affects your long-term investments?

The 80/20 rule is widely applied while making retirement plans or initiating long-term investments. For example, suppose you are investing for retirement with a long time frame, like 10 years. In that case, sticking to one main investment strategy might be more successful than considering multiple investment strategies simultaneously.

Similarly, while making a long-term investment strategy, you can set up a system where 20% of your income is automatically saved or invested. Usually, this is considered one of the best ways to build wealth over time. However, to do this effectively, you must choose an amount you can easily save each month without affecting your current lifestyle. Also, if possible, increase this amount by 20% each year.

For more clarity, let’s have a look at different ways in which you can employ the 80/20 rule while planning your retirement or formulating a long-term investment strategy:

• Put 80% of your money in retirement accounts and the remaining 20% in high-yield securities.
• Invest 80% in passive index funds and 20% in real estate.
• Allocate 80% to blue-chip company stocks and 20% to bonds or small and mid-cap company stocks.
• Use 80% of your savings for real estate investments and the remaining 20% for bonds.

Always remember that you can alter the allocation of funds in various permutations and combinations. The perfect allocation will largely depend on your financial goals and what you want to achieve with the 80/20 rule.

What are the drawbacks of the 80/20 rule?

The 80/20 rule has its benefits but has some drawbacks, especially when used for investment decisions. For a better comprehension, let’s check out some key limitations to consider:

• The 80/20 rule is not a guarantee of future performance. It is just a strategy for allocating assets and has no binding on how well your investments will do in the future.
• It must be noted that investment strategies can't be strictly defined by rules. For example, a high net worth individual (HNI) might be comfortable investing 80% in stocks, but this might not suit someone with less wealth and a lower risk tolerance.
• For proper implementation of the 80/20 rule, individuals usually need professional advice. This could be expensive and seem like an additional financial burden.
• Numerous studies have shown that the 80/20 rule isn't always accurate or applicable to all types of investments. For example, there's no assurance that 80% of your returns will come from 20% of your investments, especially when investing in stocks or mutual funds.
• This rule works best when you have enough information to assess your investments. If you are new to investing and don't understand your risk tolerance, this strategy might not be suitable for you.

Furthermore, relying too much on the 80/20 rule might cause you to miss out on good investments and can limit the diversification of your portfolio. You cannot always expect only 20% of your portfolio/ clients/ investments to generate 80% of your returns. By doing so, you can also get sidetracked from the bigger picture. Hence, as a solution, you must focus on all the assets and securities that are a part of your portfolio (not just 20%) and keep tracking their performances.

Key Points

• This principle suggests that roughly 80% of outcomes (outputs) come from 20% of causes (inputs). Applied to investing, it implies a small portion of your holdings might contribute to a significant portion of your returns.
• Allocate 80% of your portfolio to lower-risk assets like index funds and 20% to potentially higher-growth assets like individual stocks.
• Identify the 20% of your holdings driving the majority of your returns and consider adjusting your portfolio accordingly.
• The 80/20 rule is a general guideline, not a rigid formula.
• Tailor your investment approach based on your individual risk tolerance and financial goals.

Key Points

• This principle suggests that roughly 80% of outcomes (outputs) come from 20% of causes (inputs). Applied to investing, it implies a small portion of your holdings might contribute to a significant portion of your returns.
• Allocate 80% of your portfolio to lower-risk assets like index funds and 20% to potentially higher-growth assets like individual stocks.
• Identify the 20% of your holdings driving the majority of your returns and consider adjusting your portfolio accordingly.
• The 80/20 rule is a general guideline, not a rigid formula.
• Tailor your investment approach based on your individual risk tolerance and financial goals.

Disadvantages of using the 80/20 rule

While the 80/20 rule, also known as the Pareto Principle, is a popular tool for boosting productivity, it has its disadvantages. Firstly, the rule can oversimplify complex issues. Not all problems or tasks can be boiled down to a simple 80/20 split, and relying on this principle may lead to important factors being overlooked.

Secondly, the 80/20 rule can promote complacency. By focusing on the 20% that yields the most results, there's a risk of neglecting the remaining 80%, which may still be critical to overall success. This could lead to incomplete solutions and missed opportunities.

Thirdly, the rule can be misleading in dynamic environments. In rapidly changing scenarios, what constitutes the vital 20% can shift, making it difficult to apply the principle consistently. This can result in misguided priorities and inefficient use of resources.

Moreover, the 80/20 rule can foster a short-term mindset. By prioritising immediate gains, long-term objectives may be undermined. This short-sightedness can be particularly detrimental in fields requiring sustained effort and strategic planning.

Finally, the 80/20 rule may inadvertently discourage innovation. By focusing on what currently works, there's less incentive to explore new ideas and approaches, which can stifle creativity and growth. Therefore, while the 80/20 rule has its merits, it's crucial to be mindful of these potential drawbacks.

The bottom line

The 80-20 rule is a powerful concept that can help you optimise your investments in mutual funds. It can help you simplify your portfolio, enhance your returns, and align your investments with your goals. You can apply the 80-20 rule in different scenarios and ways, depending on your personal situation and preferences. However, it is always advisable to consult with a professional financial advisor before making any decisions.

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