You’ve heard of the 80/20 rule, the Pareto principle, the vital few. Call it what you want. It’s the law that states that 20% of your effort (cause) will generate 80% of your results (effect). This principle shows up in many forms. It shows up in nature, sales reports, and almost any place you can imagine. This post is about how the 80/20 rule can be used to help you be a better investor.
I’m a big data guy. I like working through data sets that would break Excel. What I found in working with data is that this rule applies to almost everything (almost eerily so). It’s one of the reasons why I think that there are a handful of retirement hacks that you can make that will generate the largest results. This is what people should be focused on: the high-impact items that can save you or make you thousands.
For instance, I’m not the type of CPA who advises people to forgo their daily latte. Saving $4 a day on lattes is not only low-impact and a waste of time. It also makes people unhappy. Instead, I say focus on the 20% of financial items that put you 80% ahead. The other items that are outside the 20% are fine to spend a little time on but you need to know that they’re not going to make a big difference to your financial picture.
I think the 80/20 rule can be used to direct how you focus your attention. While this post will focus on 80/20 investing, there are many areas of your life where you can use this simple rule. Think of all the ways that this rule applies. 80% of your sales come from 20% of your clients. 80% of the greatness of an opera comes from 20% of the music. 80% of your landlord problems come from 20% of your tenants. The list goes on and on.
I want to focus on two major things for 80/20 investing:
1) 80% of your investment returns comes from 20% of your stocks/portfolio
2) 80% of your investment success comes from 20% of your effort
After I show the 80/20 investing rule in action, we’ll move on to some broader topics.
1) Hypothesis – 80% of your investment returns comes from 20% of your stocks/portfolio
I took a look at my portfolio’s returns for last year and guess what? They follow the 80/20 rule pretty closely. As my readers know, I keep a Triad Portfolio with capital allocated to risk-free assets, core assets (stocks/bonds), and alternative assets (real estate, options). For this analysis, I’m going to focus on core portfolio to keep it simple. I had about 18 stocks in my core portfolio category last year. 5 of the 18 (or 28%) stocks accounted for about 75% of my overall return for the year (not accounting for dividends or weighting). Not exact but you get the idea.
It’s amazing to know that this rule is true for stock returns and will continue to hold true in the future. You can look no further than the S&P 500 for an example to use to see if 80% of the returns come from 20% of the stocks. I would suspect that the S&P 500 would follow the 80/20 rule closely but not exactly. Let’s see how the data shakes out.
I tried to get break out the performance by stock for 2016 but this is very difficult to find. Instead, I took the performance of stocks over the last 12-month period ending 3/17/2017. I used the data provide by Financial Visualizations. They have the best screener I’ve found to analyze performance within a group of stocks.
The top best-performing 100 stocks in the S&P 500 over the past year (that is the stocks with the greatest return for the past year – not weighted by market cap), which make up 20% of the S&P 500 returned 56%. An investor with a $1,000,000 portfolio that invested $10,000 in each of the 100 top stocks on 3/17/2016 would have a $1,560,000 portfolio on 3/17/2017.
Top 100 Stocks in the S&P 500 Past Year:
Over the last 12 months, the S&P 500 index has returned 16.9%. 242 of the 500 stocks have performed better than the overall average S&P 500 index over the past year. Pretty close to half the stocks did better than the average and a little more than half performed worse than the average.
Honeywell International (HON) is #242 on the list sorted by descending 12-month period return, with a return of 17.04%.
The best way to figure out if something is following the 80/20 rule is by breaking the data into quintiles. We already know the first quintile of the best performing S&P 500 stocks makes up 56% return.
Here’s the S&P 500 performance over the past 12 months by quintile:
1st Quintile = 56%
2nd Quintile = 31%
3rd Quintile = 16%
4th Quintile = 9%
5th Quintile = (12%) note negative
This isn’t the 56/20 rule! Why doesn’t the data fit into nice little boxes? Well, again this is more of a rule that says the results will be unevenly distributed. As you can see from the above bar chart the results are definitely not distributed evenly. Those that invest in the worst-performing 40% of stocks with equal weight will see about a 3% DECLINE in their portfolio! Ouch.
There’s Another 80/20 In The First 20%
There is another 80/20 hidden inside the top 100 S&P 500 stocks in our original list. These would be the top 20 stocks (20% of the top 100). Here are the top 20 best-performing stocks in the S&P 500 over the last 12 months:
An investor who purchased the top 20 best-performing S&P 500 stocks over the past year would have achieved a return of 95.9% on their money, almost double their initial portfolio! Look at some of the names on this list and see if you have them in your portfolio.
2) Micron Technology
4) Computer Sciences Corp
5) Idexx Laboratories
6) United Rentals
7) Applied Materials
8) Regions Financial Corp
9) Bank of America
13) Morgan Stanley
14) Zion Bancorp
15) Western Digital
17) Citizens Financial Group
18) Lincoln Financial
19) Williams Companies
There are a lot of financial and technology stocks on the list. If you have these stocks in your portfolio, congratulations. These are the best-performing 4% of stocks in the S&P 500 over the last year. We just did an 80/20 on 500 stocks showing the results of owning the top 100, then did an 80/20 on those 100 stocks showing the results of owning the top 20.
The problem, of course, is that no one knows tomorrow’s winners. The stocks on the above list may underperform the broader market in the future. What’s the point of all this 80/20 investing stuff if you can’t take advantage of the market and make money from it?
Using the 80/20 Investing Rule
The best way to take advantage of the 80/20 investing rule to focus on your top performers. Today’s top performers are likely to be tomorrow’s top performers. Just because a stock goes up this year and you’ve made a nice return doesn’t mean you should sell it to lock in a gain. You should water your flowers and pull your weeds, not the other way around as too often happens.
Let’s look at Netflix as an example of this in action (I have to add here that I bet if Netflix ever provided their streaming data, you’d see that 20% of the shows/movies account for 80% of the hours streamed. C’mon Netflix, release the data!).
An investor in Netflix during all of 2015 would have a nice return of 135%. The stock price rolled higher from $48 in January 2015 to $117 in December 2015.
Returns like this don’t come along every year. If you were sitting on this gain, you may wonder if you should sell and lock on this gains. If you did sell in December of 2015, you’d have missed 8.24% gain in 2016 (in-line with the S&P 500).
And another 17.21% in the first quarter of 2017.
An investor who sold Netflix after a great 2015 would’ve missed out on an additional $34 per share move or 31% gain over a year and a quarter.
I see stocks like this all the time. Look at the FANGs (Facebook, Apple, Netflix, Google) for example. They just keep going higher and higher. I haven’t pulled the data to test this yet so it’s just empirical evidence. It works though. Take a look at any stock that had a great year in 2015. Did that same stock outperform in 2016? Maybe it’s better to look at multi-year periods instead. It doesn’t always work this way but more times than not it does.
I’ll give you another example on a stock that under performed the broader market for me over the previous few years: Procter & Gamble (PG). Here’s a stock I thought would outperform the market. Boy was I wrong! I’ve owned P&G for a long time because of a few reasons: 1. I like consumer staples, 2. the dividend yield was decent, 3. the valuation was ok, 4. I thought their long-term outlook for sales was positive. The below chart shows how PG did compared to the S&P 500:
The S&P 500 beat PG in performance by a factor of 2: PG gained 35% over the past five years and the S&P 500 gained 72% during that same time. What did I miss here? Well, for one I didn’t realize revenues would steadily decrease over the 5-year period. I guess Harry’s razors really did chew into Gillette’s sales after all.
P&G Revenues, Net Income and Profit Margin
Source: Google Finance
I should’ve sold PG long ago. I could have sold my position in PG in 2013 and instead flipped into Netflix, which was the best-performing stock in 2013 with a gain of 269%. Even after such a huge gain, Netflix had plenty of room to run. But I like to hold onto things for a long time. It’s one of my weaknesses. I’ve since sold my position in PG.
Bullet Point Conclusion
- Pick stocks that have strong track records of delivering alpha
- Let your winners run (don’t sell)
- Allocate additional capital to your best performers
- Trim your losers (taking advantage of tax-loss harvesting)
- Realize that the returns on each stock are going to be different
- Research the top-performing S&P 500 stocks
Additional Note: I didn’t worry about market cap weighting in this section. I know you could probably say that 80% of the return of the S&P 500 comes from 20% of the stocks weighted for market cap. The big market cap winners move the index the most – I get it. I’m more focused on return on invested capital for individual investors than the weighted market cap return (focus on what matters to your wallet, not Wall Street).
2) Hypothesis – 80% of your investment success comes from 20% of your effort
The majority of your investing success will come from a few decisions. Deciding which portfolio category to allocate your capital (risk-free, core, alternative). Deciding which asset class to invest in under each portfolio category (stocks, bonds, etc.). Deciding whether to invest in actively managed funds, passive funds, or individual stocks and bonds.
There are a plethora of investments choices. This is probably why most people become paralyzed by the abundance of options. The Paradox of Choice is a great read by Barry Schwartz that shows how more choices may actually be detrimental to the decision-making process. Instead of getting caught up in the million of investments that you could possibly make, focus on the vital few that will generate the most returns.
Your effort should be focused on 3 areas:
1) Capital Allocation – Determine the amount that you’d like to have in risk-free, core, and alternative assets based on your risk tolerance, age, objectives, etc. Which investment phase are you in: Accumulation, Preservation, or Distribution?
2) Investment Types – Are you an active trader or passive indexer? Some people like to own individual stocks while still others choose to simply match the market with an index fund. You’ll either do one or the other but you should stay away from any high-cost, commission-based investment products. Active investors may choose to employ an 80/20 strategy to focus on their big-gainers.
3) Rebalancing / Income – After you have your portfolio set up, you’ll want to make sure you know what to do with it. How much money are you going to add each month? Where will this additional capital be allocated? Maybe you’re in the distribution phase and need to live off the income your portfolio generates. If that’s the case, it makes sense to focus on income structuring and figure out to pay as little in taxes as humanly possible.
All 3 of these items will generate the majority of your realized return. What are some things you do that will not generate the majority of your return?
I would say doing things like trading from one stock to the next with no real objective is detrimental. Owning stocks on a short-term basis and trying to catch a few points on a trade is no good. The secret to beating the market is by holding uber-long-term: 5 + years per position unless there’s an upcoming recession. And if you figure out when there will be a recession, let me know in the email box below.
Also, continuously analyzing different investment choices is probably not a good idea. If you’re a passive index investor, buy a passive index fund or ETF from Vanguard, Fidelity, or another low cost provider. Make it automatic and forget about it. You’ll get similar results no matter what you choose so why fret over the decision?
You should be focused on the high-impact financial decisions instead of making a bunch of smaller decisions. There are a handful of retirement hacks you should focus on. Things like carrying a mortgage in retirement, beating the tax man, and allocating your capital based on your risk budget are vitally important.
Conclusion on 80/20 Investing
The 80/20 investing rule has two different aspects:
1) 20% of your stocks (or any basket of a large number of stocks) will generate the majority of your return
2) 20% of the investment actions you take generate the majority of you return
The 80/20 investing rule follows the basic 80/20 rule, although the numbers may be off a bit. The principle is the same: a vital few actions generate the majority of results.
The graph below shows the difference between linear effort and results and exponential effort and results. The green line shows how 80% of your results stem from 20% of your effort.
One thing to keep in mind is that this 80/20 investing rule isn’t set in stone. It’s more of a general rule and shouldn’t be counted on for everything. I think that if you keep this rule in mind when making decisions, you’ll be able to achieve the greatest return with the least amount of effort.