The Pareto Principle and MF Investing

The rule of 80-20 is all-pervasive and you can find it in every aspect of life, including investments. The rule states that 80% of the effect comes from 20% of the causes. If you analyse your portfolio, you will find that 20% of your investment is generating 80% of your overall portfolio returns. This rule of 80-20 was first developed by Vilfredo Pareto, an Italian economist and mathematician. Therefore, this rule is also better known as the Pareto principle. However, it was Joseph Juran who popularised this concept in business. 

This impact of Pareto principle in the field of investments can also be best explained with the following example. If you have got a bonus of Rs 50,000 and you invest in a annual return of 10 per cent every year for the next 10 years, your investment value at the end of 10 years will be Rs 1,29,687. Now, for some reason, you delay your investment by two years and, by that time, you had spent Rs 10,000 out of your bonus money and you are left with only Rs 40,000 to invest. The expected rate of return from this fund also drops to 8% for the next eight years. Your investment value at the end of eight years will be Rs 74,037, which is lower by 42 per cent from your original investment plan. 

Contrary to this, if you had borrowed Rs 10,000 from your spouse and invested Rs 60,000 for 12 years and the expected rate of return increased to 12%, your investment corpus would be Rs 2,33,758 after 12 years, an increase of 80% from your original investment plan. 

In both the above variations of investment plan, we changed every variable by 20%. The resultant change in the investment value is huge. The reason for such a change is the compounding impact of your investment. Nevertheless, the Pareto principle is clearly visible in the above case, where a small change in the input value leads to a large change in the output value. 

Other important areas where we see the impact of the Pareto principle in mutual fund investment is in holding of stocks by mutual fund schemes. At the end of April 2018, there are 1187 mutual fund schemes holding equity as a portfolio. These schemes include hybrid and equity funds. These schemes hold 3047 unique instruments, including equity shares, nonconvertible debentures, international securities and even preference shares. 

The top 80 per cent of the entire assets under management (AUM) of these funds is held by only 10 per cent of the securities. That is, the top 300 stocks form 80 per cent of the total AUMs. Instead of 80-20, the rule is further skewed and becomes 90-10. That is, ninety per cent of the entire AUM is accounted by only 10 per cent of the stocks. 

The above analysis holds an important lesson for all of us who try relentlessly to beat market performance and generate better returns. Depending upon your risk profile, you can create a portfolio that gives you a desired return at a given level of risk. So, if you are a risk-aversive investor, you can create a portfolio that allocates 80 per cent of weightage to less volatile schemes and 20 per cent to higher volatile funds. Less volatile schemes may include large-cap dedicated funds or index funds, while volatile funds may include small-cap funds. 

The opposite also holds true if you want to take more risk, in which case, you can switch weightage the other way round with 80% asset allocated to small-cap funds. You can also use the Pareto rule to rationalise your portfolio. While reviewing your portfolio, you can identify 20 per cent of the investments that are generating most of your losses and take appropriate action regarding those schemes. This will also help you to cut through the clutter and maintain optimum number of schemes in your portfolio.