How Pareto’s 80/20 Principle Applies to Investors

You’ve likely heard of Pareto’s 80/20 Principle, coined in 1895 by Economist and Mathematician, Vilfredo Pareto. While the principle initially links to the relationships between the general population and wealth, it was soon discovered that it applies to most every life and business situation.

The Pareto Principle states that “80% of the effects come from 20% of the causes.” This mathematical principal, impressing business leaders and financiers for decades, is one that lives on as a valuable formula. In terms of investing, this summation points to the fact: we may lack balance in our financial inputs versus outputs.

One investment scenario using the 80/20 rule might look like this: 80% of your monetary returns generates by only 20% of your financial portfolio. Or, try this: 80% of the investors are failing on wise investment strategies while 20% are taking intense action. To apply the 80/20 Principle to investing, let’s first understand how the rule came about. When Pareto planted a garden of pea pods, he noticed over several growing seasons that nearly 20% of the seeds were responsible for most (80%) of the successful peas. He went on to apply his theory in other situations, which lead to the success of his 80/20 Principle.

This general mathematical principle was later instrumental in key findings by many industries:

• Pareto observed that 80% of the land in Italy was purchased from only 20% of the total population.

• For many small businesses, 80% of the revenue is derived from 20% of the customers.

• Startups report that 80% of work productivity can be generated with 20% effort.

• Tech companies realized that 80% of system crashes were due to 20% of the common viruses.

• Athletic coaches saw that 80% of athletes’ performances were impacted by 20% of their training.

• In 1989, world GDP indicated that over 80% of world capital was held by 20% of the wealthiest.

• In the area of human health and safety, nearly 80% of mishaps are caused by 20% of the hazards. If we look deeper into how the 80/20 Principle applies to investment, some notable highlights may come as a surprise and support better diversification of a financial portfolio. Smart investors create diversified portfolios with a mix of assets. The 80/20 rules might suggest 80% in safe, low-risk bonds and 20% in high-risk growth stocks.

While this balance may feel right, consider what happens with this mix in an economic decline. Stocks are volatile and risky in a time of crisis. This balance doesn’t support long-term growth, and it is not likely to keep up with inflation. In the case of a disaster, smart investors generally hold on to their stocks but create a hedge to reduce risks. A hedge is simply a more advanced investment strategy that helps reduce risks and offset the chance that your paper assets might lose value. An alternative investment often includes precious metals in the form of gold or silver.

An 80/20 rule-based portfolio that could protect your assets from inflation and market volatility might look like this: 80% in cash, stocks, and bonds and 20% in gold.

Understanding how various markets affects our assets helps us apply the 80/20 Principle. In a recession, while we know stocks decline, did you know that gold usually rises? Bonds are safe in terms of steady returns, and dollar-cost averaging is possible. In a bull market, stocks indicate growth.

Gold may rise relative to the dollar. Bonds are safe, and dollar-cost averaging is possible. In a period of inflation, your bonds are devalued as well as your cash purchasing power. Stocks can offer continued growth. Gold is vital for preserving purchasing power and growing a financial portfolio. An 80/20 based portfolio that includes gold offers an added benefit toward achieving growth and creating a hedge to withstand most any economic scenario.

While many investors are using some form of the 80/20 rule to apply to their investments, whether they know it or not, unfortunately, this split is too narrow. Most investors have 80% in one investment and 20% in another (or some similar combination). There is a diversification and hedging error in this formula if you expect to achieve asset protection against growth and inflation. In fact, according to an Investopedia article, “The greatest returns seem to be when most people expect the biggest losses.” In 2009, when the economy was struggling, less than 20% of national investors were engaging in hedging to protect their assets. They also share a statistic that “between 1992 and 2006, 80% of active traders lost money, and only 1% of them were profitable.”

There is a small but growing percentage of investors that confirm physical assets in the form of precious metals are a worthy alternative for sustaining growth and protecting capital to withstand almost any market condition. Hedging practices are a natural action to support their financial portfolios during full market cycles.

These smart investors may make up only 5-10% of the total, but they use a strategy in which a portion of their assets is safeguarded outside of banking institutions. Rather than speculate with assets, they make safe and skillful growth investments for the long term. These investors also tend to be leaders unaffected by the media and they recognize that counterfeit fiat currency is not the path to real wealth.

Turning 20% of your financial portfolio into precious metals is a strategic hedge against whatever direction an unpredictable market and economy decide to go. Making the 80/20 Principle a practical guide for your financial future could require some adjustments to your portfolio, but it may serve as a useful exercise to prepare yourself in uncertain times.

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