When it comes to investing, we all want to earn the highest return possible. There are many strategies out there to help with this endeavor. Some investors use charting tools, while others go by a fundamental analysis of the markets. But I’ve found the best route for the highest returns is to simply follow the 80-20 rule.
You might think when seeing the 80-20 rule that I am talking about putting 80% of your money into equities and the other 20% into fixed income holdings. But you would be wrong. The 80-20 rule has nothing to do with your overall allocation. It goes much deeper than that.
So let’s get started so you can start achieving the highest returns possible.
What Is The 80-20 Rule?
The 80-20 rule was developed by Vilfredo Pareto, an Italian economist. You might be familiar with the 80-20 rule as the Pareto Principle. Pareto came up with this idea when he was working in his garden. He noticed that 20% of the pea pods he planted accounted for 80% of the peas he harvested.
He then took this idea one step further and showed how 80% of Italy’s wealth was held by just 20% of its population.
Fast forward to the 1940’s and Joseph Juran applied this idea to business. He showed that during the manufacturing process, 80% of the problems in quality control resulted from 20% of the defects. Therefore, if a business focused on correcting 20% of the defects, they would see a large spike in better quality items.
The 80-20 rule has since expanded into many other areas of life. Here is a brief breakdown:
- In business, 80% of profits come from 20% of customers
- In time management, 20% of your activities will account for 80% of your results
- In business, 20% of employees account for 80% of the output
- In personal care, people wear 20% of their clothing 80% of the time
One important point about the Pareto Principle is that it is not hard and fast. What I mean by this is that it won’t always be that 20% of customers make up 80% of a company’s profits. It could be 25% of customers make up 90% of profits. So don’t get set on 80-20. The point is the idea that the majority of results comes from a small set of activity.
Applying The 80-20 Rule To Investing
When investing, you have a portfolio of many holdings. This is especially true if you own mutual funds. If you own 3 mutual funds, you could easily own 3,500 underlying stocks. But no matter how many holdings you own, the Pareto Principle applies. You will find that 80% of your returns come from 20% of your holdings.
Of course, you might also find that 80% of your losses come from 20% of your holdings. To succeed with the 80-20 rule when investing, you have to pay attention to two things.
#1. 80% of your success hinges on 20% of your actions
You could spend countless hours trying to pick great stocks, creating stop-loss orders, and such but at the end of the day, there are just a few actions you should be focused on. These few actions will make up the bulk of your success.
So what are these actions? You should figure out what your ideal allocation should be based on your risk tolerance and you should make it a point to rebalance regularly. If you can do these two things, you will experience success the majority of the time.
#2. 80% of your returns come from 20% of your holdings
So how do you make sure you are only holding winners and not losers? While history doesn’t always repeat itself, your first step should be to look at the winners in the stock market now. Who is not only succeeding today but is poised to succeed in the coming years?
These are just a few. You might be tempted to look at some beaten down stocks like General Electric or Rite Aid and think you should take a flyer on these. But remember that 80% of your returns are from 20% of your holdings.
While General Electric is beaten down, it isn’t turning the corner any time soon. It wouldn’t surprise me if the stock is still trading around $20 per share 3 years from now. In that time, you could invest in Nvidia and potentially double your money. Try investing in Motley Fool stock picks for more winners.
The 80-20 rule plays out in all areas of our lives, including investing. Remember the two keys that 80% of your returns come from 20% of your holdings and that 80% of your success comes from 20% of your actions.