You’ve probably heard of the Pareto Principle, better known as the 80/20 rule. It was first discovered in 1906 when economist Vilfredo Pareto noticed that 20% of Italians owned 80% of the country’s wealth. Since then, this pattern has shown up everywhere – but here’s what everyone misses, opines Nicholas Vardy, editor of The Global Guru.
The Pareto Principle isn’t just a productivity hack. It’s the key to understanding stock market success. A handful of stocks — not dozens or even hundreds — drive most stock market gains. And if you don’t focus on the winners and cut the losers, your portfolio will underperform.
Take a look at your portfolio right now. Chances are:
- 20% of your holdings generate 80% of your profits.
- A tiny fraction of your picks is responsible for the bulk of your returns.
But let’s take it one step further. If you own 100 stocks, about 20 of them will account for 80% of your gains. Now take the top 20 — about four of them will drive 80% of those top 20 gains.
In the end, just four stocks out of 100 — 4% — generate nearly all your portfolio’s upside. Sounds extreme? It’s not. The data backs it up.
Professor Hendrik Bessembinder of Arizona State University studied 25,300 US stocks over 90 years (1926–2016). His shocking conclusion? Just 4% of stocks accounted for the entire net gain of the US stock market.
Let that sink in. 96% of stocks didn’t move the needle! Not only did most underperform, but more than half (57%) failed to even match 1-month T-bill returns over their lifetimes.
The lesson is clear. Most investors diversify too much — but the data tells you to do otherwise. Big money is made by betting on a few high-performers and cutting dead weight.
That’s why your investment strategy should focus on two things: Identify and hold onto your big winners…and cut your losers — fast.
Master the 80/20 rule in investing and you won’t just keep up with the market — you’ll own the part that actually drives it.
