By Dan Erdle

Introduction

The Pareto Principle, known more popularly as the 80/20 rule, states that 80% of results are explained by only 20% of the inputs. Only a small amount of our time, energy, money, and decisions are responsible for a large amount of our outcomes. The Pareto principle also means that we waste much of our time on things that don’t really matter. In trying to explain the world around us we easily become distracted by noise. Instead, in trying to understand the world, we should focus our attention on figuring out the small number of things that lead to disproportionate payoffs.

 

The Pareto 80/20 Rule

The Pareto distribution contrasts with another framework that is called the normal distribution. The normal distribution takes the shape of a bell curve. The normal distribution can be a useful framework for understanding many situations, especially situations where results are independent. A classic example is something like human height which follows a bell curve distribution nicely.

However other observable phenomenon do not follow a bell curve and instead display the disproportionate impacts of the Pareto distribution. As soon as you introduce the assumption of interdependence across events, Pareto distributions tend to surface because positive feedback loops tend to amplify small initial events. For example, the fact that a website has a lot of links increases the likelihood that others will also link to the website. In mathematical terms the Pareto distribution is an example of a power law.

 

It is estimated that the world’s top 150 websites receive 30% of all traffic.  A tiny proportion of sites command most of the traffic. The top 5% probably receive 75% of the all visits. The same principle applies to traffic within sites. For example, on Twitter a very small proportion of people make up the most read tweets. Most people’s tweets are read by a couple hundred of their friends at most, but a few people’s tweets are read by millions.

More broadly, the Pareto principle reflects the fact that we live in a world with many disproportionate results. The important thing is not the exact ratio 80/20 but rather the fact the some factors produce out-sized effects. We do not live in a linear world where 1 unit of input produces 1 unit of results. Put simply we live in a world where many results are distributed unevenly.

This tends to cut against our modern preference for fairness–where causes and results are balanced roughly equally.  Living in modern society we tend to have the desire for all things to matter roughly equally and for all people to have roughly the same impact.

But this just simply isn’t the way reality is structured. Some things matter much more than others. Some inputs have much larger consequences than others.

Wealth Inequality and Other Examples

Vilfredo Pareto first noticed the tendency for unequal outcomes when he analyzed wealth.  He noticed that in 19th century Italy only 20% of the population owned 80% of the land.  This unequal distribution of wealth has persisted across time and across geographical location. In fact the story doesn’t end here because the 80/20 is fractal, meaning that it can be applied to itself. If 20% of people own 80% of the land, we can then take the 80/20 of that new 20%. In that case, 4% of people would own 64% of the land. If we then took the 80/20 of that, then 0.8% of people own 51.2% of the land. This is basically the distribution of wealth that we see in most societies throughout history.

In many contexts understanding a relatively small number of factors will help us explain most of the results. 80/20 is striking to most people because it indicates that the natural order of most systems is not an equal distribution, but an unequal distribution. Here are a bunch of examples:

• 20% of the cities in a country will have 80% of the population
• 20% of all criminals commit 80% of crimes
• 20% of drivers cause 80% of accidents
• 20% of the population produces 80% of health care expenses

Here are a few examples specific to the business/financial world:

• 20% of a business’s products will account for 80% of sales
• 20% of your sales people will make 80% your sales
• 20% of your largest customers will account for 80% of your profit

Repeated Processes Involving Differentiated Outcomes

Think about what happens when you play the board game Monopoly. Each person begins with the same amount of money. After a number of turns, often through random chance, some people start to win a bit and others start to lose. If you start winning the probability you will keep winning goes up. There is a positive feedback effect. If instead you started losing you become more vulnerable. After more time of playing if you started with 6 players most of them would have very little money and 1 or 2 would have all of the money. So the Pareto 80/20 rule applies even to situations involving large amounts of random chance because of feedback effects. The 80/20 rule is even more likely to be applicable when the phenomenon being studied involves differentiated intelligence, skills, and resources being applied in a deliberate effort to maximize outcomes.

Companies like Apple, Google and Microsoft have achieved enormous concentration of economic value creation that defies the averages of traditional thinking. For example in 2017 Apple sold only 15% of the world smartphones but captured 83% of smart phone industry profits. If you were to look up company profits you would find that the top companies don’t earn just slightly more than the average companies, they absolutely crush them. The spoils of business do not get distributed equally, they go to a select number of ultra successful companies.

The wealthiest 1% of the population has most of the money. And of that 1%, 1% of those people have most of the money. Its not the same people all of the time who have all of the money, but it is always the same tiny fraction of the people who have all the money. It is the result of any iterative process involving human beings where there is differentiation in creative output.

For example, look at how it applies to music.  Here we will use classical music. Only five composers have made the music that represents half of the classical repertoire. They are Bach, Beethoven, Brahms, Tchaikovsky, and Mozart. But the rule of disproportional results applies again at a deeper level because it is fractal.  Try looking at all of the music of each of those five composers. For each one of the composers only 5% of their total work makes up 50% of the music you hear. In other words, you only hear music from a few select musicians, and even from those great musicians only a small number of their songs ever reach popularity. Even among the greatest composers ever, most of their music never gets played, but the music that does get played gets played a lot.

Price’s Law and Productivity

Price’s Law is another power law related to the Pareto principle. Price originally studied the productive output of scientists. He found that the average scientist had published 1 article, but the very productive scientists were hyper-productive. A few scientists accounted for the majority of citations in leading publications.  Price’s law can be generalized across human domains.

Price’s law states that the square root of the number of people in a certain domain do half the work. If you have 10 employees, 3 of them do half the work. If you have 100 employees, 10 of them do half the work. In other words, with 100 employees, 10% is doing half the work while the other 90% do the other half. Now lets say you have 10,000 employees. A hundred people do half the work. That means 99% of the people do as much work as your best 100. The problem in all likelihood is that you don’t even know who your best 100 are because they are lost in the sea of people that is large corporations.

This helps explain what many people have observed about large corporations.  Large corporations become bureaucratic, dull, and stagnant. Being large carries some competitive advantages but size is not without its drawbacks. Price’s law supports the proposition that  as your company grows, incompetence grows exponentially. As more layers are added, responsibility becomes more diffused and a disconnect appears between the average employee and the output of the company.

This also helps explain how large seemingly great companies can get into a tailspin. When things are going well a company can get away with being relatively bureaucratic. This changes once things get difficult. If things aren’t going well at your company the very best people with the most outside options are likely to leave first. In a corporation of 10,000 people if you lose only your best 100 people you have wiped out half your productive output. You are left with the 9,900 who produced the other half. But now that you have lost your best people things really start getting bad. And now your next best 100 people leave who were then producing a large amount of the output. By only losing a small amount of people you have suffered a drastic reduction in productivity while retaining almost all of your payroll expenses.

An Important Lesson From Investing

Investing is difficult because it seems like there is almost an unlimited amount of information we could analyze. From important macro factors, to specific balance sheet line items, it sometimes feels like the complexity is too much to take into account.  But like most domains, when it comes to investing it is likely only a small handful of factors that do the vast majority of the heavy lifting.  When we approach investing we should take the lessons of the Pareto principle to heart and avoid trying to do everything and instead focus our time and attention on only the most important things.

Here is one example of something that has huge explanatory power in investing. It is an excellent example of the power laws we have been talking about because of its disproportionate impact. It is a business’s Return on Invested Capital. Not the recent returns of the stock in the market but the returns the business itself is able to generate on the capital available to it. In the chart created by Credit Suisse we see valuation multiple on the vertical axis and Cash Flow Return on Investment on the horizontal.  CFROI is essentially analogous to ROIC.  Both attempt to see how well the company uses available resources by comparing return per unit of capital available to it.

What we see is that business valuation and that business’s capital returns have a correlation coefficient of .83. This indicates a strong correlation. What is perhaps more interesting is the r-squared of a data set which explains how much of the variance is explained by the independent variable.  .83 squared is .68.  What this means is that almost 70% of the variance in business valuation is explained by differences in Return on Invested Capital.

This is unbelievable. One factor explains 70% of business valuation differences in the S&P 500.  Think about how many things investors consider and how many theories you hear about how you should approach investing.  It is almost impossible to believe that everything you hear is noise and that 70% of the difference in business valuation is attributable to only one thing. Armed with only Return on Invested Capital you can capture the vast majority of what a business is worth.

If I had to guess, the remaining 30% of the variance can be explained by growth.  I haven’t seen any specific data to back it up but it is my strong inclination that Return on Invested Capital coupled with a companies growth rate would explain almost all of the variance in business valuation. Could it really be that in all the supposed complexity of investing, the value of a business really comes down to only two factors?

Is it really true that basically the only two things we need to know to value a business is its ROIC and its Growth Rate?

After considering the Pareto Principle and other power laws it actually wouldn’t surprise me.  In so many places of understanding it really is only a small number of things doing most of the work. But often what you will find around those few important factors is almost always a tremendous level of noise and complexity that masks the real driving forces.

Investing is likely any other domain and a relatively small amount of inputs explain the outputs. This gets lost on most people. Most people assume that if you want extraordinary results you have to do extraordinary things.  This just isn’t the case. What you do have to do is focus your efforts and have the clarity of thought to pick out the truly important things from all the inconsequential.

The Myth of Hard Work

If you understand the 80/20 rule you will come to the conclusion that most of the social cliches about the value of hard work are in need of re-evaluation.  Its not that the social platitudes are completely wrong it is just that they seriously fail to convey the whole truth.  Its not that you should be lazy and not work. But it is incredibly important to understand that it is not your level of work that will determine your success but rather what your work actually consists of. The key point is that each unit of work (or time) doesn’t contribute the same amount.

Bill Gates is not 1,000,000 times more wealthy than the average person because he works 1,000,000 times harder than everyone else.  He was able to find a way that the work he did resulted in massively disproportionate payoffs.  If you ask wealthy people why they are wealthy they are almost sure to include hard work as one of the primary reasons. Don’t listen to them. They don’t know what they are talking about. Wealthy people are not wealthy because they work harder than other people. In fact, most wealthy have never really seen a hard days work in their life.

If hard work was really what made people rich, brick layers would fill the Forbes 400.  But I guarantee that you could go through the entire Forbes 400 and not find a single person there because of their labor.  Everyone in the Forbes 400 is a capitalist.  You are looking at a group that received huge payoffs because of how they allocated their time, money, and attention.  It’s not the total amount of work that wealthy people do, its that they focus their time and money on the highest returning activities. Each member of the Forbes 400 is there, not because of their hard work as an employee, but because they have an equity ownership interest in one or more successful businesses.

But I think wealthy people probably honestly do believe that they are wealthy because of hard work.  Hard work is so pounded into our heads as a social virtue that people who do achieve wealth automatically assume that they are hard working.  It somehow just feels morally correct that people should have wealth because of hard work. But our social sentiments just don’t align with reality. In fact, the reality is that the big payoffs come to those who maximize results per unit of work. This means maximizing output while minimizing inputs.

Luckily for rich people the Pareto principle works whether you are conscious of it or not.  They can keep going on thinking they are rich because of hard work while the 80/20 rule does the work behind the scenes. My guess is that most wealthy people sort of stumble their way into benefiting from the 80/20 principle.  Very few rich people have ever heard of Vilfredo Pareto, but they happen to engage in activities that benefit from disproportionate payoffs.

Key Takeaways to Remember

• It’s almost certain that we are all doing too much of the wrong things and not enough of the right things.
• Small moves, smartly made, can lead to exponential improvements in wealth creation provided they leverage the deep structures that define Pareto distributions.
• Focus your attention not on maximizing your inputs such as work, time, and money; instead focus on where and how they are being allocated.
• We can probably cut 80% of the things we do in our personal lives and our corporations without really losing too much.  Most of the things we do are relatively useless even though they don’t seem that way.
• Power Laws seem to have a fundamental place in how the universe is structured: it applies to everything from wealth to website traffic.
• Disproportionate outcomes are particularly present in any human domain involving an iterative process with differentiated outcomes such as music, writing, business, etc.
• Investing is like many other pursuits–a small number of things carry most of the weight.  Focus on figuring out the few things that really drive results. It is almost certain that you should include a business’s Return on Invested Capital as one of those things.
• Find a small number of things that you are sure are important and focus all of your time, money, and energy in those spots.
• Avoid needless activity; It’s just as important what you keep out as what you let in.