What could an Italian economist from a century ago have to do with successful investing today?
Vilfredo Pareto noted back in 1906 that some 80% of the land of Italy was owned by just 20% of the population.
He then developed his principle by observing that 20% of the pea pods in his garden contained 80% of the peas.
This observation eventually led to what is now known as the Pareto Principle or more commonly, the ‘law of the few’ or the 80/20 Rule: that 80% of the effects or outputs are often derived from 20% of the causes or inputs.
All fields of life
The 80/20 Rule is a gem of a principle because it appears to occur in so many fields of life.
In business? You might find that 80% of your sales (and complaints!) are derived from 20% of your customers.
In health and safety? Do 20% of the hazards that cause 80% of the injuries or accidents?
In customer service? Microsoft found that by fixing the top 20% of the most reported bugs, 80% of the errors and crashes could be eliminated.
Wealth? Does just 20% of the population hold 80% of the wealth of a nation? Often.
The same applies to the wealth of the world.
The law of the few even seems to apply to subsets of the income range: the world’s richest 3 men own as much as the next 7 put together.
The implication of all this?
Focus on getting the big decisions right.
How do we apply this to investment?
Warren Buffett once said that we don’t need to make too many great decisions; we just need to limit the quantum and the magnitude of the bad ones.
Another way of saying this is that if we lose too much we can’t win overall. This is well demonstrated in the table below:
|% asset falls in value||% recovery to break even|
|100||Impossible to recover|
If an asset falls in value to zero, it is worthless: it can never recover.
The implication of the table above is to seek assets with which show proven growth over the long term, and leave the speculative vehicles to the speculators.
Less can be more…
The best property investors are often those who make fewer decisions.
What do I mean by that?
Well, the most successful investors I have seen are very often those who have bought and held on to prime location properties over a long period of time, rather than those who are constantly buying and selling in order to time the market.
The high transaction costs and the effect of capital gains tax ensure that high-frequency trading is usually an impractical approach to property investment.
Remember that 80% of your outputs are likely to come from 20% of your inputs.
Successful property investors should therefore concentrate on making fewer but bigger decisions. Due to the use of leverage, property investors can often make a huge difference to their net worth even by only acquiring a handful of assets.
It’s all about the power of focus.