Applying Pareto for financial planning

Last week, we discussed the role of the Pareto Principle (80/20 rule), which suggests that around 80% of the outcomes or effects come from a relatively small portion (around 20% of inputs). Today, we review how the approach is evident in equity investing through a quick study of the top 10 large-cap mutual funds.

First, let’s use Pareto to establish some basic guidelines.  Investing 80% of your money into equity is more prudent during the early phase of your earning career. As you approach retirement, the numbers can be reversed, i.e. 80% of your funds can be invested in debt and the balance in equity (variations apply based on your specific situations).   Second, if you are a new equity investor, experts advise investing in large-cap funds compared to higher-risk mid and low-cap categories to balance the risk vs return. Third, if you are investing directly in stocks, you could use the concept of Pareto to ensure that the core part of your portfolio (i.e. 15 to 25%) of your stocks, which are likely to beat the indices consistently, covers 40 to 70% of the total value.  Let me share some analysis on large-cap funds to provide a new perspective.

I conducted a small study of the top 10 large-cap funds. Based on one of the top assessment websites, I shortlisted the top 10 ranked funds based on ten-year performance. All (100%) of these funds had beaten the overall category performance!  Moreover, across these funds, about 19% of the stocks covered nearly 50% of the total money (the average number of stocks for these ten funds was 55).  After this, I explored the presence of the top three financial company stocks in these ten funds. Company A was chosen by 100% of these funds, Company B was in 90%, and Company C was in 50%.  In other words, the country’s experts on large-cap mutual funds across their fund-house also prioritise where they invest, and their approach has common threads.  Therefore, if you invest in big companies in India through the mutual fund route, it is worth exploring the top funds that consistently beat the category index for 7-10 years unless you have additional skills that these leading funds’ managers don’t have! The same prioritisation principles based on Pareto can be extended to flexi-cap and other category funds selection.

The above findings increased my curiosity. Hence, I randomly sampled portfolios of 5 individuals who invest directly in stocks.  Unfortunately, only 1 (20%) of these portfolios had beaten the index; the rest were behind!  For many, the top 10 stocks covered less than 30% of the total value, a meagre amount compared to some of the best-performing funds managed by the experts. This left me with a few questions: (1) what makes us think that we can choose to invest directly into stocks and deliver better returns, more consistently than some of the top mutual fund managers? (2) If, as highlighted earlier, >90% of the top large-cap mutual fund experts invest in Companies A and B, is there a reason for the individual stock investors to either ignore these companies and pursue other companies not chosen by these top mutual fund experts? Unfortunately, when top mutual funds select these stocks for various reasons, the probability of index-beating results is reduced due to likely higher valuations.  Hence, this option of blindly copying the stock selection of top mutual funds is not easy (3) If you wish to invest in equity, it is prudent to focus on lower-risk (e.g. large cap) funds for 80% of your investment and over a few years, you can diversify to other higher-risk options.

Therefore, the concept of Pareto (or 80/20 rule) provides several insights for the common investors, including which mutual fund category to prioritise and which specific funds to select.  If you are an expert in stock picking, Pareto also provides a framework to ensure that core ten stocks cover a meaningful portion of your total investment.  Finally, depending on your unique life stage and situation, consider applying the 80/20 rule in distributing the hard-earned wealth into equity vs debt.