• FIC Hansraj

Pareto Principle

“Life isn’t fair”. These words are often heard from people who pin all of their despair on life or luck in particular.

Even a toddler screams at the top of their lungs if their sibling receives more chocolates from their mother. This shows that an understanding of things “not being equally distributed” is easy to decipher and is fed into our brains from a young age. We are going to delineate this principle in more detail as you read further and witness its presence in the finance world where it is called the “Pareto Principle” or the “80/20 rule”.

Pareto principle Rule of Causes and Consequences | FIC Hansraj Blog

The Pareto Principle states that 80% of consequences come from 20% of the causes, indicating an unequal relationship between inputs and outputs. It reiterates the “unfair/unequal distribution” we talked about earlier as it illustrates that the relationship between inputs and outputs is not balanced. The name of the Principle is coined after the Italian economist Vilfredo Pareto who first used it in 1906 to describe the distribution of wealth in Italy in the early 20th century. He noticed that 20% of the pea pods in his garden were responsible for 80% of the peas. He further expounded that 80% of the wealth in Italy belonged to only 20% of the population.

This principle which is also termed as the phenomenon of “the vital few and the trivial many" is often misinterpreted. The 80/20 split holds for Pareto’s observation. It isn’t a hard and fast rule that the numbers have to be “80%” and “20%” exactly. Pareto Principle is upheld even if 10% of the causes give rise to 90% of the consequences. The key point to understand here is that each unit of input in terms of effort, time, and labour doesn’t result in the same amount of output. Also, the numbers 80 and 20 aren't necessarily supposed to add up to 100. For example, 30% of the workers may complete 80% of the work as the other workers may not be that productive. Thus, we can also notice that the Pareto Principle is not a law but an observation.

Almost every economic activity around us is subject to this principle. Some real-life examples would demonstrate that we often apply the Pareto Principle unconsciously in our everyday decisions. The rule can be applied when we make our budgeting decisions. When we decide to save 20% of our income and spend 80% on our needs and wants, we are bringing the 80/20 rule into the picture which is a simplified version of the 50/30/30 budget rule. Coming to investing, it would be often noticed that 80% of our investment returns would come from only 20% of our asset allocations. This would also help us make investment decisions by examining our portfolio and recognizing those handful securities contributing to 80% of our returns. We can then eliminate those idle assets from our portfolio to finally have a portfolio that holds the top gainers and cuts off the top losers. However, this is not set in stone as it’s impossible to predict the behaviour of our investments.

It’s imperative for us to understand how we can benefit from this principle when we are aware that such a phenomenon exists. The 80/20 rule helps us to identify those inputs that are the most productive so that we know to prioritize them as they drive 80% of our results. When 80% of a company’s revenue is generated by 20% of its customers, the company can focus on cultivating a relationship with those clients and the market in particular. The principle can be applied across all domains of a business, be it manufacturing, management, finance, or HR. 20% of the products can contribute to 80% of the sales which can give deep insights regarding the inventory. When 20% of defects in a car lead to 80% of the crashes, a manufacturer can save time, effort, and money by fixing those flaws instead of revamping the entire car.

In a nutshell, this is not a perfect world where planning is difficult as each factor doesn’t contribute the same amount. This is not restricted to finance and can be applied to our personal lives as well. It can go a long way in helping us with time management. 80% of our day’s output can come from only 20% of the time spent towards generating the output. A student often tries to prioritize those chapters that will have the most number of questions in the question paper. However, the principle never instructs to ignore the other 20% entirely. It primarily helps us to identify the potential drivers for our activity. Thus, we should implement this concept in all areas of decision making and see how things change for the better.