What Is the Pareto Principle?
The Pareto Principle is a concept that specifies that 80% of consequences come from 20% of the causes, asserting an unequal relationship between inputs and outputs. Named after economist Vilfredo Pareto, the Pareto Principle serves as a general reminder that the relationship between inputs and outputs is not balanced. The Pareto Principle is also known as the Pareto Rule or the 80/20 Rule.
Key Takeaways
- The Pareto Principle states that 80% of consequences come from 20% of the causes.
- The principle was derived from the imbalance of land ownership in Italy.
- It is commonly used to illustrate the notion that not all things are equal and the minority owns the majority.
- The Pareto Principle is merely an observation—not a law.
- Broadly applied, it does not apply to every scenario.
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Understanding the Pareto Principle
The principle was developed by Italian economist Vilfredo Pareto in 1906 and was dubbed the Pareto Principle by Joseph M. Juran in the 1940s. Pareto observed that the majority of the wealth (80%) was owned by a minority (20%) of the people. According to what Pareto observed, 80% of the land in Italy was owned by 20% of the population. After surveying other countries, he found the same applied abroad. For the most part, the Pareto Principle is an observation that things in life are not always distributed evenly.
The Pareto Principle can be applied in a wide range of areas such as manufacturing, management, and human resources. It suggests that the efforts of 20% of a corporation's staff could drive 80% of the firm's profits. The Pareto Principle is even more applicable to businesses that are client-service based. It has been adopted by a variety of coaching and customer relationship management (CRM) software programs.
It can also be applied on a personal level. Time management is the most common use or the Pareto Principle. That's because most people tend to thinly spread out their time instead of focusing on the most important tasks. In terms of personal time management, 80% of your work-related output could come from only 20% of your time at work.
Advisory practices that have adopted the Pareto Principle have seen improvement in time management, productivity, and overall client satisfaction.
Special Considerations
The Pareto Principle seems simple but is hard to implement for the typical financial advisor. The principle suggests that since 20 clients are paying 80% of the total fees, they should receive at least 80% of the customer service. Advisors should, therefore, spend most of their time cultivating the relationships of their top 20 clients.
However, as human nature suggests, this does not always happen. Most advisors tend to spread out their time and services with less regard to a client’s status. If a client calls and has an issue, the advisor deals accordingly, regardless of how much income the client brings to the advisor.
Advantages and Disadvantages of the Pareto Principle
Advantages
There is a practical reason for applying the Pareto Principle. Simply, it can give you a window into who to reward or what to fix. For example, if 20% of the design flaws in a car are leading to 80% of the crashes, you can identify and fix those flaws.
Similarly, if 20% of your customers drive 80% of your sales, you may want to focus on those customers and reward them for their loyalty. In this sense, the Pareto Principle becomes a guide for how to allocate resources efficiently.
Disadvantages
While the 80/20 split is true for Pareto's observation, that doesn't necessarily mean that it is always true. That's because it is based on anecdotal evidence rather than scientific analysis. For instance, 30% of the workforce (or 30 out of 100 workers) may only complete 60% of the output. The remaining workers may not be as productive or may just be slacking off on the job. This further reiterates that the Pareto Principle is merely an observation and not necessarily a law.
The principle has also led to advisors focusing on replicating the top 20% of their clients, knowing that adding a client of that size immediately affects the bottom line.
Pros
Pinpoints who to reward and what to fix
Provides a guide on how to allocate resources
Cons
May not always be accurate as it is derived on anecdotal evidence rather than scientific analysis
May lead advisors to replicate the top 20% of their clients
Example of the Pareto Principle
Financial advisory businesses commonly use the Pareto Principle to help manage their clients. The business depends on the advisor’s ability to provide excellent customer service, as its fees rely on its customers’ satisfaction.
However, not every client provides the same amount of income to the advisor. If an advisory practice has 100 clients, according to the Pareto Principle, 80% of the financial advisor’s revenue should come from the top 20 clients. These 20 clients have the highest amount of assets and the highest fees charged.
How Does the Pareto Principle Work?
The Pareto Principle is a concept that suggests that 80% of the end results of an action are due to 20% of causes. That's why this principle is also called the 80/20 rule. Keep in mind that the Pareto Principle is an observation—not a law. In business and finance, the principle is used to determine which inputs are the most profitable and productive. This allows the observer to make changes and prioritize them.
Does the Pareto Principle Always Work?
The Pareto Principle or 80/20 Rule is generally considered to be valid. But this is not through scientific analysis. Rather, its validity comes from anecdotal evidence. As such, the principle is an observation and not considered a firm law.
How Can I Use the 80/20 Rule to Invest my Money?
Th 80/20 rule can be applied to different scenarios, including how to invest your money. When it comes to your investments, the principle is used to focus on choosing the right assets so you can balance your risk and reward. That said, you'll want to maximize the 20% in your portfolio that will give you 80% of your returns.
Applying the principle depends on your investment style and strategy. For instance, you may want to invest 80% of your portfolio in safe assets and 20% in riskier classes. Consider speaking to a financial professional about how the Pareto Principle can be applied to your investment strategy.
The Bottom Line
There are many ways you can apply the Pareto Principle. Companies can use it to determine whether certain strategies are working and where to make improvements. Investors can also use it to help them achieve their investment goals. Keep in mind that there is no scientific evidence that backs up the principle. This means it may not be foolproof and should be taken with a grain of salt.
