Do you follow the 80/20 rule?
During the past century this simple ratio has developed into one of the most useful concepts and tools of modern-day routine.
In a moment, I'll show you how you can use a version of the 80/20 rule to help take your portfolio to a whole other level.
First, some background ...
The 80/20 rule assumes that most of the results in any situation -- sales, finance and even personal relationships -- are determined by a small number of events.
Pareto reportedly developed the principle after observing similar scenarios in everyday life, including the fact that 80% of the peas in his garden came from only 20% of the pea pods.
Then came Joseph Juran, a quality management pioneer in the United States in the 1930s and '40s. In citing "Pareto's Principle," Juran postulated that 20% of product defects caused 80% of product problems. Before you can say "supply-chain management," there emerged a veritable cottage industry of 80/20 maxims.
- 80% of sales come from 20% of the sales force
- 80% of the profits come from 20% of the customers
- 80% of growth comes from 20% of the product line
- 80% of future business comes from 20% of the current customer base
- 80% of your innovation comes from 20% of your employees
The percentages are not precise, of course, but they're close enough merit consideration.
Why bother? Because the competitive edge goes to those who know how to use this information to their advantage.
Says author and marketing professional Bryan Eisenberg: Instead of giving the best salespeople the most difficult accounts, for instance, "let them focus their talent in areas where they could generate extraordinary volumes."
Similarly, Eisenberg observes, "The most highly skilled workers are often given the toughest work," but "concentrating their skills on trouble-free jobs would allow them to produce significantly more than less-skilled coworkers."
So what does the 80/20 rule have to do with beating the market?
Plenty, according to Andy Obermueller, Chief Strategist for Game-Changing Stocks.
Andy is StreetAuthority's resident expert in small companies with big potential.
|(Note: In case you haven't heard, Andy just put the finishing touches on his latest batch of astounding predictions. They're big, bold, and give you a window into the future unlike anything you've ever seen. He's spent hundreds of hours researching the ideas behind them -- and his past predictions have returned 92%... 293%... even 310% gains -- so I urge you to check them out. You can do so by clicking here.)|
Twice each month in Game-Changing Stocks, Andy presents a new technology, methodology or concept that can "change the baseline assumptions for doing business in its industry," as he likes to put it.
Andy was one of the first analysts to recognize the potential of what at the time was an unheard-of Israeli company that was trying to carve a niche in an untapped market -- homemade carbonated beverages.
|Since Andy's recommendation in February 2012, SodaStream (Nasdaq: SODA) rose 93.6% to a record $77.80 a share last month, before easing off the highs (and he still recommends SODA at any price below $70).
Last summer, Apple (Nasdaq: AAPL) put in a bid of $8.00 a share for mobile security company AuthenTec -- more than three times the price at which Andy recommended the game-changer less than a year earlier.
The edge goes to those who know how to use this information to their advantage.
In May 2012 Andy put the spotlight on Westport Innovations (Nasdaq: WPRT), a Canadian maker of natural-gas-powered truck engines, which at the time was trading at $24.11 a share. After quickly running up to $40.16 a share two months later, WPRT is currently showing a gain of "only" 33.1%.
In Andy's version of the 80/20 rule, those are the "20%" companies -- aggressive growth stocks that can juice your overall portfolio even if the other 80% is more conservatively invested.
How does it work? I'll let Andy tell you himself...
|Bob: Your regular readers are already familiar with your 80/20 rule, but can you explain it for the rest of our audience?
Andy: It works like this: Put 80% of your assets into something considered relatively safe. Maybe it's U.S. Treasurys, maybe it's S&P 500 companies. That's a subjective judgment, based on one's personal risk tolerance, and every investor will be different. This 80% segment of your portfolio goes on autopilot and collects a reasonable return.
The remaining 20% goes into the most aggressive growth plays an investor feels comfortable with. These have the potential to deliver knockout results. All it takes is one big winner. In Game-Changing Stocks, my job is to help investors find those winners.
Bob: Show us the math.
Andy: OK. Presume that 80% block of assets is allocated to the S&P in a low-cost index fund. What can we expect? Well, history tells us that the average annual return of the S&P is roughly 10.5%. That works out to an 8% annual return when compounded annually. So 80% of your portfolio earns 8% a year on average.
These funds are not to be touched. The market does the heavy lifting. Some years are up, some are down, the average is 8%. And if more dollars are added to the portfolio, 80 cents out of each dollar would go to the S&P as well.
The rest goes into game-changers -- the companies that can knock the cover of the ball, like Authentec or SodaStream or Westport. Those were all huge gains, but we can't count on every play returning triple digits. And I should point out that that sort of hyperrational thinking is crucial to this method of investing. So let's say we're able to achieve 30% a year in our aggressive growth portfolio.
Even though it accounts for only 20% of the portfolio, the higher rate of return changes the average annual gain to 12.4%. Big whoop, right? But that seemingly miniscule bump, over time, is huge.
If you have a $100,000 portfolio and just earn the 8%, after 25 years you end up with $684,848. Not bad. But if you can earn 12.4%, then your total is $1,858,480. As I said, that's huge. And remember, 30% is distinctly doable with game-changers. Plus the majority of the portfolio is on autopilot.
The difference over time between returns of a $100,000 portfolio that reflects
the likely performance of the S&P 500 and an "80/20" portfolio
(assuming a 30% annual return in the 20% block)
Bob: You just released your latest "predictions" report. Can you share one of them with us today?
Andy: I think SodaStream is going to go bonkers. Not long ago, a rumor surfaced that Pepsi (NYSE: PEP) was going to buy it. Shares shot up. Now, that deal never materialized, but the fact is that the Street believed it. Why? It's plausible. SodaStream created a new market, and it's a market with big potential.
Let me give you three reasons: City dwellers, who don't want to carry heavy cases of soda home; restaurants, which are always looking for another high-margin cocktail to sell; and yoga parents, who equate homemade with better, fresher and healthier for their kids. Those are powerful forces. And SodaStream is leveraging them very well, which is why its machines are positioned in 60,000 retail outlets from Wal-Mart (NYSE: WMT) to Williams-Sonoma (NYSE: WSM).
Andy: I've been thinking about how some companies value innovation and creativity and what that can mean for the culture and the direction of the organization. A bank, for instance, can be a very good bank even if it, as a matter of course, slams the door on any new idea. Lots of companies are like this. They execute well. They do what they are supposed to do.
But that led me to thinking about companies that do what they aren't supposed to do, and I started bumping into Google almost immediately. Why is Google putting in 1-gigabit Internet service in Kansas City? Why is it funding grad students' strange theoretical mathematical papers? Why did it build a car that can drive itself?
The answer is, Google is doing all these things because it can. And it wants to. The corporate culture is one of innovation. Its unofficial motto is, "Yeah, let's try that." So they get a bunch of really smart people into a room and there's one word written on a whiteboard.
That's revolutionary. That's where ideas come from. Everyone talks about how Google does so much for its workers. Free food. Playing games. Massages. They get the works, plus a very nice salary in a nice place to live. That's sheer genius. Spend a few bucks on lattes and back rubs and get the best minds in world thinking about your corporate priorities... Who wouldn't do that?
Well, the unfortunate answer is very few companies do. And that's why most companies miss out on the most powerful force in business -- innovation. Innovative companies have about double the annual return of non-innovative companies. I actually proved this in the current issue of Game-Changing Stocks using R&D spending data.