There are a number of practical applications for the 80-20 rule in diverse areas such as the distribution of wealth in economics, quality production control, business sales, and growth. The 80-20 rule was invented by Vilfredo Pareto in Italy in 1906. According to legend, Pareto, an economist, noticed 20% of the pea pods in his garden provided 80% of the peas. He then determined 20% of the population in Italy owned 80% of the land. Use of the 80-20 rule has since expanded beyond the alleged humble beginnings in Pareto’s garden.
Dr. Joseph Juran applied the 80-20 rule to quality control in the 1940s. He found that 80% of problems with products were caused by 20% of the production defects. By focusing on and reducing that 20% of production defects, overall quality could be increased. Juran became an important figure in Japan after lecturing there extensively on quality control issues. His main phrase was, "the vital few and the trivial many."
The 80-20 Rule in Business and Investments
The 80-20 rule has found applications in business management. For business sales, 20% of a company’s customers are responsible for 80% of the sales. Also, 20% of the employees are responsible for 80% of the results. For project management, many managers have noted the first 20% of the effort put in on a project yields 80% of the project’s results. Thus, the 80-20 rule can help managers and business owners focus 80% of their time on the 20% of the business yielding the greatest results.
In investing, the 80-20 rule generally holds that 20% of the holdings in a portfolio are responsible for 80% of the portfolio’s growth. On the flip side, 20% of a portfolio’s holdings could be responsible for 80% of its losses. Another method is to attempt to focus a portfolio on that 20% of stocks in the broader market that comprise 80% of the market’s returns. However, due to the uncertainty of future returns, both of these methods are difficult to put into practice. Stocks are inherently risky assets due to the unpredictability of future performance.
One method for using the 80-20 rule in portfolio construction is to place 80% of the portfolio assets in a less volatile investment, such as Treasury bonds or index funds while placing the other 20% in growth stocks. The 80% in the lower-risk investment will collect a reasonable return, while the 20% in the higher-risk assets will hopefully achieve greater growth.
(For related reading, see: The Pareto Principle and Savings.)