The 80-20 Rule: What is it & how it works? (2024)

While stock market investors rely on several rules to formulate their investment strategies, the 80-20 rule remains the most famous. Before we proceed, if you're wondering, 'what is the 80-20 rule?' - it simply means that 80% of your portfolio's gains come from 20% of your investments.

Here's how this rule plays out in the world of finance and the US stock market.

Importance of the 80-20 rule in investments

Commonly known as the Pareto Principle, the infamous 80-20 rule was ideated by Italian economist, Vilfredo Pareto. While the theory was developed when studying garden pea production levels, it is vital today in the assessment of macroeconomics, finance, budgeting, trading, risk diversification, and several other avenues.

Now, how does the 80-20 rule work in the US stock market? Here are a few 80-20 rule examples:

• 80% of your portfolio's returns in the market may be traced to 20% of your investments.
• 80% of your portfolio's losses may be traced to 20% of your investments.
• 80% of your trading profits in the US market might be coming from 20% of positions (aka amount of assets owned).
• 80% of the US stock market capitalisation comes from around 20% of the S&P 500 Index.

Common ways of using the 80-20 rule in investments

Now that you know what the 80-20 rule is, it's time to see how it is beneficial in designing and changing your investment approach:

Hedging Risks

By parking 80% of your funds in relatively safer asset classes, you can balance out the risk associated with diversification. For instance, you can invest 80% of your funds in savings bonds, while 20% can be invested in growth stocks or invest 80% in a retirement account and 20% in a taxable portfolio.

Diversifying your trading strategies

Also called system diversification, mixing trading strategies can allow you to maximise returns. If you find 1 or 2 trading strategies guiding 80% of your gains after analysis, you should decide when to focus on these key strategies and when to tweak the underperforming ones.

Deciding on indicators

Investors rely on indicators to gauge the value of a stock. However, adding too many indicators to the mix can give you contradictory readings. Using the 80-20 rule, you can decide which indicators give you the most actionable insights and plan your strategy better.

Rebalancing your portfolio

Rebalancing your investment portfolio lets you trim your losses. By redirecting your funds to the 20% of assets driving 80% of your portfolio's gains, you can minimise losses and cut loose non-profitable investments.

Conclusion

The 80-20 rule is not stock market fail-safe — it's more a basis for evaluating your investments and not predicting what will earn you more. However, investing 80% in blue-chip stocks and 20% in small to mid-cap stocks may be safer if you're dabbling in the US Stock market. To do so, you can bank onFi Money— 0 commission. 0 brokerage. 0 withdrawal fee. Fi enables you to invest in top US companies — at industry-best forex rates. So you can own shares in Apple, Tesla, Microsoft, and so on!

Frequently Asked Questions

1. What Does the 80-20 Rule Mean?

The Pareto Principle or 80-20 rule helps identify the most efficient way of doing things that will bring the most returns. For example: In the investment world — it implies 80% of your returns are from 20% of your holdings. The 80-20 rule is widely used in business, management, and other fields, like the US stock market.

2. What are some examples of the 80-20 rule?

Based on the application of famed economist Vilfredo Pareto's 80-20 rule, here are a few examples:

• 80% of your stock market portfolio's profits might come from 20% of your holdings.
• 80% of a company's revenues may derive from 20% of its clients.
• 20% of the world's population accounts for 80% of its wealth.