Wednesday, 5 February 2014

We are all slaves to the Pareto principle

You may know it as the '80-20 rule' but aficionados know it as the Pareto principle that, roughly, 80% of the effects come from 20% of the causes.

Investors see this all the time.  Even when we are busy constructing that wonderfully balanced mix of diversified multi-sector investment choices, most of our gains and benchmark differentiated performance comes from just a handful of those positions.  As one of my old bosses used to say: 'if you find a doubler it is going to make a difference' (he was right, it does). 

Of course we don't know which 20% and that is why diversification and a reasonable number of positions matter. Invariably it is not the 20% an investor, if pushed, would highlight.  I think it was the great Peter Lynch who pointed out that the best stock performers were often the second tier and not the top tier choices of analysts.  That is my experience too. 

Anyway I thought about the Pareto principle when I read, as part of the media frenzy surrounding the Facebook 10th anniversary celebrations that Bono, the lead singer of U2, is likely to make multiples more money from his relatively early stage Facebook stake than all his years at the top of the rock music pile.  It is probably even better than '80-20' in this case. 

As investors we all dream of such a '80-1' outcome, allowing us to put a share certificate on the wall from the small cap which turned into an industry behemoth, hence depicting our investment selection excellence.  What many forget though is that the chances of chancing upon such an opportunity AND holding it through to a full fruition is suitably negligible.  On a doubler most of us praise the skies and sell at least half 'to get our base capital back'.  That's not going to give you a '80-1' outcome of any capital materiality. 

Accept the Pareto principle and work with it.  As in life, you get luckier with investments the harder you work.  Hopefully you can then spot some of the 20% of your investment book who are going to be the stars and buy a few more. 

As for Bono, he just got dead lucky - not that he needs the money. 

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