What Is the 80-20 Rule?

The 80-20 rule, also known as the Pareto Principle, is a familiar saying that asserts that 80% of outcomes (or outputs) result from 20% of all causes (or inputs) for any given event.

In business, a goal of the 80-20 rule is to identify inputs that are potentially the most productive and make them the priority. For instance, once managers identify factors that are critical to their company’s success, they should give those factors the most focus.

Although the 80-20 rule is frequently used in business and economics, you can apply the concept to any field. Wealth distribution, personal finance, spending habits, and even infidelity in personal relationships can all be the subject of the 80-20 rule.

How Does the 80-20 Rule Work?

You may think of the 80-20 rule as simple cause and effect: 80% of outcomes (outputs) come from 20% of causes (inputs). The rule is often used to point out that 80% of a company’s revenue is generated by 20% of its customers.

Viewed in this way, it might be advantageous for a company to focus on the 20% of clients that are responsible for 80% of revenues and market specifically to them. By doing so, the company may retain those clients, and acquire new clients with similar characteristics. However, there’s a more fundamental meaning to the 80-20 rule.

Core Principle

At its core, the 80-20 rule is about identifying an entity’s best assets and using them efficiently to create maximum value. For example, a student should try to identify which parts of a textbook will create the most benefit for an upcoming exam and focus on those first. This does not imply, however, that the student should ignore the other parts of the textbook.

Misinterpretations

People may not realize that the 80-20 rule is a precept, not a hard-and-fast mathematical law. Furthermore, it is isn’t necessary that the percentages equal 100%. Inputs and outputs simply represent different units. The percentages of these units don’t have to add up to 100%. It’s the concept behind the rule that matters.

There’s another way in which the 80-20 rule is misinterpreted. Namely, that if 20% of inputs are most important, then the other 80% must not be important. This is a logical fallacy. The 80% can be important, even if the decision is made to prioritize the 20%.

80-20 Rule Background

The 80-20 rule is also known as the Pareto principle and is applied in Pareto analysis. It was first used in macroeconomics to describe the distribution of wealth in Italy in the early 20th century. It was introduced in 1906 by Italian economist Vilfredo Pareto, who is best known for the concepts of Pareto efficiency.

Pareto noticed that 20% of the pea pods in his garden were responsible for 80% of the peas. Pareto expanded this principle to macroeconomics by showing that 80% of the wealth in Italy was owned by 20% of the population.

In the 1940s, Dr. Joseph Juran, a prominent figure in the field of operations management, applied the 80-20 rule to quality control for business production.

He demonstrated that 80% of product defects were caused by 20% of the problems in production methods. By focusing on and reducing the 20% of production problems, a business could increase the overall quality of its products. Juran referred to this phenomenon as “the vital few and the trivial many.”

Benefits of the 80-20 Rule

Although there is little scientific analysis that either proves or disproves the 80-20 rule’s validity, there is much anecdotal evidence that supports the rule as being essentially valid, if not numerically accurate.

Performance results of salespeople in a wide range of businesses have demonstrated success by incorporating the 80-20 rule. In addition, external consultants who use Six Sigma and other management strategies have incorporated the 80-20 principle in their practices with good results.

Example of the 80-20 Rule

A Harvard graduate student, Carla, was working on an assignment for her digital communications class. The project was to create a blog and monitor its success during the course of a semester.

Carla designed, created, and launched the site. Midway through the term, the professor conducted an evaluation of the blogs. Carla’s blog, though it had achieved some visibility, generated the least amount of traffic compared with her classmates’ blogs.

Define the Problem

Carla happened upon an article about the 80-20 rule. It said that you can use this concept in any field. So, Carla began to think about how she might apply the 80-20 rule to her blog project. She thought, “I used a great deal of my time, technical ability, and writing expertise to build this blog. Yet, for all of this expended energy, I am getting very little traffic to the site.”

She now understood that even if a piece of content is spectacular, it is worth virtually nothing if no one reads it. Carla deduced that perhaps her marketing of the blog was a greater problem than the blog itself.

Apply the 80-20 Rule

To apply the 80-20 rule, Carla decided to assign her 80% to all that went into creating the blog, including its content. Her 20% would be represented by a selection of the blog’s visitors.

Using web analytics, Carla focused closely on the blog’s traffic. She asked herself:

• Which sources comprise the top 20% of traffic to my blog?
• Who are the top 20% of my audience that I wish to reach?
• What are the characteristics of this audience as a group?
• Can I afford to invest more money and effort into satisfying my top 20% readers?
• In terms of content, which blog posts constitute the top 20% of my best-performing topics?
• Can I improve upon those topics, and get even more traction from my content than I’m getting now?

Carla analyzed the answers to these questions, and edited her blog accordingly:

1. She adjusted the blog’s design and persona to align with her top 20% target audience (a strategy common in micromarketing).
2. She rewrote some content to meet her target reader’s needs more fully.

Significantly, although her analysis did confirm that the blog’s biggest problem was its marketing, Carla did not ignore its content. She remembered the common fallacy cited in the article—if 20% of inputs are most important, then the other 80% must be unimportant—and did not want to make that mistake. She knew it was necessary to address aspects of the content, as well.

Results

By applying the 80-20 rule to her blog project, Carla came to understand her audience better and therefore targeted her top 20% of readers more purposefully. She reworked the blog’s structure and content based on what she learned, and traffic to her site rose by more than 220%.

What Is Adverse Selection?

Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality. In other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party.

Typically, the more knowledgeable party is the seller. Symmetric information is when both parties have equal knowledge.

In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase products like life insurance. In these cases, it is the buyer who actually has more knowledge (i.e., about their health). To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.

Understanding Adverse Selection

Adverse selection occurs when one party in a negotiation has relevant information the other party lacks. The asymmetry of information often leads to making bad decisions, such as doing more business with less profitable or riskier market segments.

In the case of insurance, avoiding adverse selection requires identifying groups of people more at risk than the general population and charging them more money. For example, life insurance companies go through underwriting when evaluating whether to give an applicant a policy and what premium to charge.

Underwriters typically evaluate an applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record, and lifestyle risks such as smoking; all these issues impact an applicant’s health and the company’s potential for paying a claim. The insurance company then determines whether to give the applicant a policy and what premium to charge for taking on that risk.

Consequences of Adverse Selection

A seller may have better information than a buyer about products and services being offered, putting the buyer at a disadvantage in the transaction. For example, a company’s managers may more willingly issue shares when they know the share price is overvalued compared to the real value; buyers can end up buying overvalued shares and lose money. In the secondhand car market, a seller may know about a vehicle’s defect and charge the buyer more without disclosing the issue.

The general consequence of adverse selection is that it increases costs since consumers lack information held by sellers or producers, creating an asymmetry in the market. This can also lower consumption as buyers may be wary of the quality of the products that are offered for sale. Or, it may exclude certain consumers that do not have access to or cannot afford to obtain information that could lead them to make better buying decisions.

One indirect effect of this is a negative impact on consumers’ health and well-being. If you buy a faulty product or dangerous medication because you don’t have good information, consuming these products can cause physical harm. Or, by refraining from buying certain healthcare products (e.g., vaccines), consumers may wrongly judge a safe intervention as overly risky.

Adverse Selection in Insurance

Because of adverse selection, insurers find that high-risk people are more willing to take out and pay greater premiums for policies. If the company charges an average price but only high-risk consumers buy, the company takes a financial loss by paying out more benefits or claims.

However, by increasing premiums for high-risk policyholders, the company has more money with which to pay those benefits. For example, a life insurance company charges higher premiums for race car drivers. A car insurance company charges more for customers living in high-crime areas. A health insurance company charges higher premiums for customers who smoke. In contrast, customers who do not engage in risky behaviors are less likely to pay for insurance due to increasing policy costs.

A prime example of adverse selection in regard to life or health insurance coverage is a smoker who successfully manages to obtain insurance coverage as a nonsmoker. Smoking is a key identified risk factor for life insurance or health insurance, so a smoker must pay higher premiums to obtain the same coverage level as a nonsmoker. By concealing their behavioral choice to smoke, an applicant is leading the insurance company to make decisions on coverage or premium costs that are adverse to the insurance company’s management of financial risk.

Another example of adverse selection in the case of auto insurance would be a situation where the applicant obtains insurance coverage based on providing a residence address in an area with a very low crime rate when the applicant actually lives in an area with a very high crime rate. Obviously, the risk of the applicant’s vehicle being stolen, vandalized, or otherwise damaged when regularly parked in a high-crime area is substantially greater than if the vehicle was regularly parked in a low-crime area.

How to Minimize Adverse Selection

Adverse selection by increasing access to information, thus minimizing asymmetries. For consumers, the internet has greatly increased access while reducing costs. Crowdsourced information in the form of user reviews along with more formal reviews by bloggers or specialist websites are often free and warn potential buyers about otherwise obscure issues around quality.

Warranties and guarantees offered by sellers can also help, allowing consumers to use a product risk-free for a certain period to see if it has flaws or quality issues and the ability to return them without consequence if there are issues. Laws and regulations can also help, such as Lemon Laws in the used car industry. Federal regulatory authorities such as the FDA also help ensure that products are safe and effective for consumers.

Insurers reduce adverse selection by requesting medical information from applicants in the form of requiring paramedical examinations, querying doctors’ offices for medical records, and looking at one’s family history. This gives the insurance company more information that an applicant may fail to disclose on their own.

Moral Hazard vs. Adverse Selection

Like adverse selection, moral hazard occurs when there is asymmetric information between two parties, but where a change in the behavior of one party is exposed after a deal is struck. Adverse selection occurs when there’s a lack of symmetric information prior to a deal between a buyer and a seller.

Moral hazard is the risk that one party has not entered into the contract in good faith or has provided false details about its assets, liabilities, or credit capacity. For instance, in the investment banking sector, it may become known that government regulatory bodies will bail out failing banks; as a result, bank employees may take on excessive amounts of risk to score lucrative bonuses knowing that if their risky bets do not pan out, the bank will be saved anyhow.

The Lemons Problem

The lemons problem refers to issues that arise regarding the value of an investment or product due to asymmetric information possessed by the buyer and the seller.

The lemons problem was put forward in a research paper, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,” written in the late 1960s by George A. Akerlof, an economist and professor at the University of California, Berkeley. The tag phrase identifying the problem came from the example of used cars Akerlof used to illustrate the concept of asymmetric information, as defective used cars are commonly referred to as lemons. The takeaway is that due to adverse selection, the only used cars left on the market will ultimately be lemons.

The lemons problem exists in the marketplace for both consumer and business products, and also in the arena of investing, related to the disparity in the perceived value of an investment between buyers and sellers. The lemons problem is also prevalent in financial sector areas, including insurance and credit markets. For example, in the realm of corporate finance, a lender has asymmetrical and less-than-ideal information regarding the actual creditworthiness of a borrower.

The Bottom Line

Contrary to assumptions made by mainstream economic and financial models, information is not symmetrically accessible and available to all actors in a market. In particular, sellers and producers often have far more information about what they are selling than do buyers. This information asymmetry can lead to market inefficiencies via what is known as adverse selection. In insurance markets, applicants have more information about themselves than do insurers, meaning that they withhold key information about being higher-risk.

What Is an Agency Problem?

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In corporate finance, an agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize their own wealth.

Understanding Agency Problems

The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as possible, they are given the responsibility to perform in whatever situation results in the most benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example, the plumber may make three times as much money by recommending a service the agent does not need. An incentive (three times the pay) is present, causing the agency problem to arise.

Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal’s or client’s best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court’s assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

Minimizing Risks Associated With the Agency Problem

Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.

Regulations

Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients’ interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest.

For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client’s best interest.

Incentives

The agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal’s best interests. For example, a manager can be motivated to act in the shareholders’ best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing, or the threat of takeovers.

Principals who are shareholders can also tie CEO compensation directly to stock price performance. If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem. However, if the CEO was compensated based on stock price performance, the CEO would be incentivized to complete the takeover. Stock prices of the target companies typically rise as a result of an acquisition. Through proper incentives, both the shareholders’ and the CEO’s interests would be aligned and benefit from the rise in stock price.

Principals can also alter the structure of an agent’s compensation. If, for example, an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.

Real-World Example of an Agency Problem

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. The company’s executives used fraudulent accounting methods to hide debt in Enron’s subsidiaries and overstate revenue. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings.

In the four years leading up to Enron’s bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron became the largest U.S. bankruptcy at that time with its $63 billion in assets. Although Enron’s management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.