Anyone who has studied business or economics is familiar with the power of the Pareto Principle – commonly referred to as the 80/20 Rule.
What is Pareto’s 80/20 Rule:
This rule deals with the universal concept about the imbalance of inputs and outputs. While it does not always come out to be exactly an 80/20 ratio, this imbalance is often seen in various business cases:
• 20% of the most reported software bugs cause 80% of software crashes
• 20% of patients account for 80% of healthcare spending (and 5% of patients account for a full 50% of all expenditures)
On a personal side, my smartphone has 30 different mobile apps pinned to the screen, but 80% of the time I’m only using the six on my home screen. If you are like me, most of my clothes are the same 20% of the possible wardrobe collection.
First the Man Behind the Concept:
Vilfredo Pareto was born in Italy in 1848, and would become an important philosopher and economist. The story is that one day he noticed that 20% of the pea plants in his garden generated 80% of the healthy pea pods. This observation caused him to think about uneven distribution. He thought about wealth and discovered that 80% of the land in Italy was owned by just 20% of the population. He investigated different industries and found that 80% of production typically came from just 20% of the companies. Thus, the generalization became: 80% of the results will come from 20% of the action.
Nice to know, but why am I discussing this concept on a financial planning blog?
Well, it so happens that when you evaluate the long-term results of the stock market that this rule also applies.
A study analyzing over 14,000 active stocks and their performance returns between 1989 and 2015 identified the best performing stocks on both an annualized return and a total return basis. Looking at the total returns of the individual stocks, 1,120 stocks or just 7.7% of active stocks outperformed the S&P 500 index by at least 500% during this time period. Likewise, 976 stocks (6.8% of all active stocks) lagged the S&P 500 by at least 500%. The remaining 12,404 stocks performed above, at or below the same level as the S&P 500.
So, let’s say an investor’s portfolio missed the 20% most profitable stocks between 1989 and 2015. Instead, she invested in only the other 80% (over 12,000 companies). Her total gain would have been 0%. Once again, the principle holds true: over the long term, the more efficient approach is to ensure that you have the 20% of all the stocks that drive the total aggregate return.
Another way to look at the returns is this data from financial advisor Ben Carlson:
40% of US stocks experienced a catastrophic loss (70% loss that never recovers).
2/3 of stocks underperformed the overall stock market.
More than 40% of stocks experienced negative returns on an absolute basis.
10% of all stocks were the big winners…..
Now the million-dollar question: How to capture the 10% to 20% of the stock market winners?
Answer: Invest in the entire stock market… And that includes the global stock market. This way you are guaranteed to capture the aggregate stock market return. The track record of individuals trying to select just the 20% that will outperform the market is dubious. There is no need. Own the entire stock market.
Hope you have a great week!
If you know of anyone that you think would appreciate this email, please don’t hesitate to forward it on.