How the 80/20 Rule Affects Your Long-Term Investments
What is the 80/20 rule?The 80/20 rule focuses on maximizing the 20% of factors that will generate the best results. It can be used to identify a firm’s best-performing assets and use them efficiently to create maximum value for the investors. For instance, even in a well-diversified portfolio, a few of your investments may outperform the rest by a huge margin resulting in massive gains for you.
How does the 80/20 rule work?As far as investing is concerned, if you invest in different assets, it’s likely that some will outperform others. The fact that numerous factors contribute to investment success does not necessarily mean every asset type will turn out to be profitable. For instance, if you have 20 different investments, chances are only one or two of them will generate great returns. Let’s say you have invested in 10 different asset classes. One of those investments was an exchange-traded fund (ETF), which is known for providing steady returns over time. Now, here the ETF returns may make for 80% of your total portfolio returns. In other words, the idea behind the 80/20 rule is that if you focus on the best performing 20% of your investments, chances are they will outperform the remaining 80%.
Can the 80/20 rule be used for long-term investments and retirement planning?The 80/20 rule can be helpful when planning for retirement or the long term. For instance, if you’re investing for retirement and have a long time horizon, say 10 years give or take, then focusing on just one investment strategy may lead to more success than working with multiple strategies simultaneously. When it comes to long-term planning, you can develop a mechanism where at least 20% of your income gets auto-credited to your savings and investment schemes. This can be a great way to build wealth over time. However, choose an amount that you can easily invest every month while maintaining your current standard of living. If possible, increase the investment amount by 20% every year. Some ways in which you can implement the 80/20 rule in your retirement planning and investments are:
- Invest 80% of your funds in retirement accounts and the remaining 20% in high-yield securities
- Invest 80% of your money in passive index funds and the remaining amount in real estate
- Invest 80% of your money in blue-chip company stocks and the remaining 20% in bonds or small and midcap stocks
- Use 80% of your savings to invest in real estate and the remaining 20% in bonds.
What is the 80/20 rule in finance?The 80/20 rule in finance works on the principle of ‘vital few’ and ‘trivial many.’ In finance, you can use the 80/20 rule for important activities such as budgeting, asset allocation, and planning. For instance, when budgeting, you can divide your strategy into allocating 80% to retirement savings and 20% to expenses. Let us understand the 80/20 rule with the help of an example. Assume you have $100,000 to invest. Of this, you invest 80%, i.e., $80,000 in stocks. Let’s assume that you purchase 800 shares of Company X for $100 each. The remaining $20,000 are invested in real estate. In 2 years, Company X’s share price rose to $250/share. Your total investment value now stands at $200,000. At the same time, assume your real estate investment doubled to $40,000. Your total portfolio value stands now at $240,000. As you can see, more than 80% of your returns came from a single asset class – equities. As simple as the rule appears, in reality, the situation is quite complex. There is no accounting done for inflation. Also, there is a good chance that your asset growth remains stagnant. Furthermore, the risk is extremely high here, with 80% allocation to equities. And that’s why, besides all its advantages and uses, the 80/20 rule is a generic principle, which may not work out on all profiles and asset classes.
What are the drawbacks of the 80/20 rule?The 80/20 rule, despite its many benefits, has certain drawbacks as well. If you’re using the 80/20 rule to make investment decisions, here are some limitations to consider:
- The 80/20 rule can, at best, be only an asset allocation strategy. It has no binding on how investments will perform in the future.
- Asset allocation and strategy cannot be confined to rules. A lot of personal and situational factors may come into play. For instance, a high-net-worth individual may have the risk appetite to invest 80% in equities. The same may not hold true for other individuals having lesser net worth.
- If you want to implement the 80/20 rules, you may require professional guidance, which can be an expensive affair.
- The 80/20 rule is not always accurate or applicable to all investments. For example, if you are investing in mutual funds or stocks, there is no guarantee that your portfolio may yield 80% returns from these investments alone.
- The 80/20 rule only works when there are enough data points to accurately assess whether an investment will be successful or not. If you’ve never invested before and don’t know how much risk you’re willing to take when investing in stocks, or other asset types, then this strategy may not be suitable for you.
- You may miss out on good investments due to this rule and it may also affect diversification of your investments as well.