Pareto Principle Definition - Investopedia

The Pareto Principle specifies that 80% of consequences come from 20% of the causes, asserting an unequal relationship between inputs and outputs. Economy Economics WhatIstheParetoPrinciple? TheParetoPrinciple,namedaftereconomistVilfredoPareto,specifiesthat80%ofconsequencescomefrom20%ofthecauses,assertinganunequalrelationshipbetweeninputsandoutputs.Thisprincipleservesasageneralreminderthattherelationshipbetweeninputsandoutputsisnotbalanced.TheParetoPrincipleisalsoknownastheParetoRuleorthe80/20Rule. KeyTakeaways TheParetoPrinciplestatesthat80%ofconsequencescomefrom20%ofthecauses.Theprinciple,whichwasderivedfromtheimbalanceoflandownershipinItaly,iscommonlyusedtoillustratethenotionthatnotthingsareequal,andtheminorityownsthemajority.Unlikeotherprinciples,theParetoPrincipleismerelyanobservation,notlaw.Althoughbroadlyapplied,itdoesnotapplytoeveryscenario. 2:23 TheParetoPrinciple(80-20Rule) UnderstandingtheParetoPrinciple TheoriginalobservationoftheParetoPrinciplewaslinkedtotherelationshipbetweenwealthandpopulation.AccordingtowhatParetoobserved,80%ofthelandinItalywasownedby20%ofthepopulation.Aftersurveyinganumberofothercountries,hefoundthesameappliedabroad.Forthemostpart,theParetoPrincipleisanobservationthatthingsinlifearenotalwaysdistributedevenly. TheParetoPrinciplecanbeappliedinawiderangeofareassuchasmanufacturing,management,andhumanresources.Forinstance,theeffortsof20%ofacorporation'sstaffcoulddrive80%ofthefirm'sprofits.TheParetoPrinciplecanbeappliedespeciallythosebusinessesthatareclient-servicebased.Ithasbeenadoptedbyavarietyofcoachingandcustomerrelationshipmanagement(CRM)softwareprograms. Itcanalsobeappliedonapersonallevel.TimemanagementisthemostcommonusefortheParetoPrinciple,asmostpeopletendtothinlyspreadouttheirtimeinsteadoffocusingonthemostimportanttasks.Intermsofpersonaltimemanagement,80%ofyourwork-relatedoutputcouldcomefromonly20%ofyourtimeatwork. ExampleoftheParetoPrinciple FinancialadvisorybusinessescommonlyusetheParetoPrincipletohelpmanagetheirclients.Thebusinessisdependentontheadvisor’sabilitytoprovideexcellentcustomerservice,asitsfeesrelyonitscustomers’satisfaction.However,noteveryclientprovidesthesameamountofincometotheadvisor.Ifanadvisorypracticehas100clients,accordingtotheParetoPrinciple,80percentofthefinancialadvisor’srevenueshouldcomefromthetop20clients.These20clientshavethehighestamountofassetsandthehighestfeescharged. Important AdvisorypracticesthathaveadoptedtheParetoPrinciplehaveseenimprovementintimemanagement,productivity,andoverallclientsatisfaction. TheParetoPrincipleseemssimplebutishardtoimplementforthetypicalfinancialadvisor.Theprinciplesuggeststhatsince20clientsarepaying80percentofthetotalfees,theyshouldreceiveatleast80%ofthecustomerservice.Advisorsshould,therefore,spendmostoftheirtimecultivatingtherelationshipsoftheirtop20clients. However,ashumannaturesuggests,thisdoesnothappen.Mostadvisorstendtospreadouttheirtimeandserviceswithlessregardtoaclient’sstatus.Ifaclientcallsandhasanissue,theadvisordealsaccordingly,regardlessofhowmuchincometheclientactuallybringsintotheadvisor. Theprinciplehasalsoledtoadvisorsfocusingonreplicatingtheirtop20%ofclients,knowingthataddingaclientofthatsizeimmediatelyaffectsthebottomline. AdvantagesoftheParetoPrinciple ThereisapracticalreasonforapplyingtheParetoPrinciple.Simply,itcangiveyouawindowintowhotorewardorwhattofix.Forexample,if20%ofthedesignflawsinacarareleadingto80%ofthecrashes,youcanidentifyandfixthoseflaws.Similarly,if20%ofyourcustomersaredriving80%ofyoursales,youmaywanttofocusonthosecustomersandrewardthemfortheirloyalty.Inthissense,theParetoPrinciplebecomesaguideforhowtoallocateresourcesefficiently. DisadvantagesoftheParetoPrinciple Whilethe80/20splitistrueforPareto'sobservation,thatdoesn'tnecessarilymeanthatitisalwaystrue.Forinstance,30%oftheworkforce(or30outof100workers)mayonlycomplete60%oftheoutput.Theremainingworkersmaynotbeasproductiveormayjustbeslackingoffonthejob.ThisfurtherreiteratesthattheParetoPrincipleismerelyanobservationandnotnecessarilyalaw. ArticleSources Investopediarequireswriterstouseprimarysourcestosupporttheirwork.Theseincludewhitepapers,governmentdata,originalreporting,andinterviewswithindustryexperts.Wealsoreferenceoriginalresearchfromotherreputablepublisherswhereappropriate.Youcanlearnmoreaboutthestandardswefollowinproducingaccurate,unbiasedcontentinour editorialpolicy. ColoradoDepartmentofTransportation."ParetoAnalysis." CompareAccounts AdvertiserDisclosure × TheoffersthatappearinthistablearefrompartnershipsfromwhichInvestopediareceivescompensation.Thiscompensationmayimpacthowandwherelistingsappear.Investopediadoesnotincludealloffersavailableinthemarketplace. Provider Name Description RelatedTerms HowtoApplythe80-20Rule The80-20rule,alsoknownastheParetoPrinciple,usedmostlyinbusinessandeconomics,statesthat80%ofoutcomesresultfromjust20%ofcauses. more HowParetoAnalysisandthe80/20RuleWork Paretoanalysisstatesthat80%ofaproject'sresultsaredueto20%ofthework,orconversely,80%ofproblemscanbetracedto20%ofthecauses. more WhatIsWelfareEconomics? Welfareeconomicsfocusesonfindingtheoptimalallocationofeconomicresources,goods,andincometobestimprovetheoverallgoodofsociety. more UnderstandingtheLaborTheoryofValue Thelabortheoryofvalue(LTV)wasanearlyattemptbyeconomiststoexplainwhygoodswereexchangedforcertainrelativepricesonthemarket. more WhatIsaMarketEconomy? Amarketeconomyisasysteminwhicheconomicdecisionsandpricingareguidedbytheinteractionsofcitizensandbusinesses. more Capitalism Capitalismisaneconomicsystemwherebymonetarygoodsareownedbyindividualsorcompanies.Readontofindoutaboutvariousformsofcapitalism. more PartnerLinks RelatedArticles AutomatedInvesting Wealthfrontvs.VanguardPersonalAdvisorServices:WhichIsBestforYou? AutomatedInvesting PersonalCapitalvsVanguardPersonalAdvisorServices:WhichIsBestforYou? AutomatedInvesting Bettermentvs.VanguardPersonalAdvisorServices:WhichIsBestforYou? AutomatedInvesting ProsandConsofUsingaRobo-Advisor AutomatedInvesting VanguardPersonalAdvisorServicesvs.E*TRADECorePortfolios:WhichIsBestforYou? PracticeManagement WhyClientsFireTheirFinancialAdvisors