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The 80/20 Rule: Why Only a Handful of Investors Reap Most of the Profits

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There’s this relatively old concept that has been gaining popular traction over the last decade or so, and it’s become increasingly popular across multiple disciplines and professions: the 80/20 principle.

The general principle goes something like this: 80% of the effects come from 20% of the causes.

For those of you who are unfamiliar with the 80/20 principle, it may sound a bit odd, a bit speculative, perhaps even a bit pseudo-scientific.

But it actually stands on solid mathematical footing; and theory aside, you can observe it at work virtually anywhere.

As an investor, it’s an important principle to bear in mind, not only because roughly 20% of your portfolio may be generating 80% of your returns but also because the top 20% of investors do something that the rest of the 80% tend to neglect.

We’ll get to that in a moment. First, let’s talk more about this 80/20 principle and discuss why it’s important, and eventually how you might apply it to your own investing.

Vilfredo Pareto’s Discovery

In the late 19th century, an Italian economist and mathematician by the name of Vilfredo Pareto made an important discovery while engaged in, among all things, gardening.

He noticed that of all the pea pods he planted, roughly 20% of the pods produced the majority of peas. He noticed how this unequal distribution seemed to happen consistently.

Eventually, a light bulb must have gone off when he started noticing this distribution happening elsewhere beyond his garden. Hence, the Pareto Principle was born (popularly referred to today as the 80/20 principle).

What started off as a theory, and a complex mathematical paper, the 80/20 principle, over time, became a prevalent and observable phenomenon:

  • Pareto himself noticed that 80% of Italy’s land was owned by 20% of the population.
  • World GDP in 1989 showed that the richest 20% held 82.70% of the world’s capital.
  • Microsoft noticed that fixing 20% of the most reported bugs resolved 80% of the crashes.
  • In athletic training, coaches noted that only 20% of the exercises impacted 80% of an athlete’s overall performance.
  • In occupational health, it’s been noted that 80% of all injuries were attributable to 20% of the hazards.
  • Video rental stores in the ’80s and 90’ noted that 80% of their revenue came from 20% of their product.
  • Businesses, in general, have noted that 80% of their revenue comes from 20% of their customers.
  • Corporate psychologists have noted that 80% of your work productivity comes from 20% of your effort.

So, how does this unequal distribution take place in the domain of investing? And how might you take advantage of it?

What 20% of the Most Successful Investors Do That the 80% Neglect

In a diversified portfolio consisting of stocks and bonds, stocks are there to provide growth while bonds serve to provide income plus a relative degree of safety.

But during periods of decline, stock volatility can increase as much as three times its normal volatility. This means stocks carry most of the risk.

The most successful investors counter this risk, not by selling their stocks, but by hedging their positions.

Some investors may allocate 80% of their portfolio to bonds and 20% to stocks. But the problem with this is that the stocks may not generate enough long-term growth.

Also, an 80/20 distribution of stocks and bonds will likely not keep pace with inflation, even at an average 3% annual inflation rate.

So, many successful investors will hedge by allocating a portion of their portfolio to assets that will move counter to market and dollar declines, that is gold.

By keeping the distribution of 20% gold and 80% dollar-denominated assets like stocks, bonds, and cash, you are protecting your money from both market volatility and inflation.

Here’s one relatively conservative way to approach it:

  • During a recession, stocks decline, gold often rises, bonds provide steady fixed income, while cash on reserve can be used to dollar cost average any asset projected to see growth or protection.
  • During a bull market, stocks provide growth, gold may also rise relative to dollar and interest rates movements, bonds provide steady income, and cash can be used to dollar cost average.
  • During periods of inflation, bond coupon payments are devalued, cash purchasing power is devalued, stocks might still provide growth to keep pace with inflation, while gold serves as the primary driver for both portfolio growth and purchasing power preservation.

This kind of 80/20 distribution keeps your portfolio on track toward achieving growth while maintaining its active hedge through virtually any economic environment.

More importantly, including gold in your portfolio is the only way to achieve both growth and capital preservation through periods of inflation.

The Top 20% Among the Most Successful 20%

If you were to ask around, you may find that most investors don’t actively hedge their portfolio in the manner described above. And among those who do hedge, you may find that most of their portfolio holdings cannot achieve both growth and inflation protection across all three environments.

Among those who invest in the markets, the most successful 20% know how to hedge their portfolio.

But among that 20 %, a smaller 20% know how to sustain growth and protect their capital across ALL market conditions.

These are the 4% of investors who carry physical gold in their portfolios, the 20% among the 20%.

To this class of investors, growth and volatility protection is not enough. They want to generate growth and remain hedged across all market cycles.

Wary of the machinations of Wall Street, they remain independent, forming their own opinions, making their own decisions, and on terms that are most advantageous to their financial well-being.

Fully aware that banks are carrying massive leverage, these investors choose to safeguard a portion of their wealth outside of the banking system, and for good reason.

Successful investors don’t speculate with their money. They know how to play the game: investing is about generating a steady stream of growth, not placing reckless wagers--it’s a game of skill, not luck.

They know from experience that certain forms of “money” and assets will grow under certain conditions, hence, they keep a diversified basket of assets in all times.

These 4-percenters do not allow their investment decisions or sentiment to be swayed by financial media, as occupying the top 4% requires one to be a leader rather than a follower.

Lastly, they know that artificial money (fiat currency) can only build artificial wealth.

And although many of them enjoy this artificial wealth, they’re well-hedged against this artificiality with a stash of gold and silver.

Apportioning 20% of your portfolio to gold and silver may not seem like a big step. But when the next financial crisis strikes--and financial crises are inevitable--then that 20% allocation may be what saves the remaining 80% of your portfolio’s value.

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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