The 80/20 Theory
Now that I have pulled myself back from the edge of the proverbial cliff and come to terms with the fact that there is no such thing as “good customer service”, I want to share a theory I have been working on.
Remember, I like to keep things simple and this theory is as simple as they come. In the spirit of business Monday, I will keep this explanation on point as far as business, the markets and the economy in general.
My theory is this with regards to investing: We, as investors know roughly 80% of what we need to know to make an informed investment decision. There will always be, at minimum, a 20% variable of the unknown. This can hold true for times of moderate market moves and unexplainable upward movements.
When, we as investors feel confident with the amount of information we are receiving about any particular investment idea, we can feel fairly confident we are making a wise investment choice. You can drill down into this anyway you like but the fact remains, we gather information, listen to informed opinions and make a decision. No investor will know every variable regarding the pricing of an investment but with 80% of the knowledge known, you can be pretty sure you got it right. Not all of that 80% knowledge gathered is positive however, so that has to be factored in as well.
Where things get dicey is when the unknown variable increases above a certain percentage. I like to think that once we get to a point of around 60-40 (60% being the known quantity, 40% being the unknown) markets can retreat steadily. What we saw last March was something around 20-80. We knew about 20% of what we needed to know to invest and 80% was a complete unknown.
“Markets abhor a vacuum” the old adage goes and that is actually where this theory stems from. Last March, we were in a vacuum of knowledge and the markets quickly took it on the chin. I wrote about this in an earlier Substack. We had very little clarity from the old administration or the new one. We did’t know what the following months were going to bring. We knew around 20% of what we needed to know. That 80% caused a meltdown in equity markets across the globe.
If you ascribe to this theory religiously, you probably would have missed one the most powerful moves in market history so it is not perfect but the rally that ensued after the selloff was more about undoing the shock and realizing the end of the World was not near(yet). Investors flooded back into various markets while still operating at something akin to a 50-50 market knowledge ratio. Still a risky bet but there were known forces helping out the unknown simply by putting more and more cash out there. You know there is money coming, you don’t know what impact it will have. You know that you can’t go to Aruba for winter vacation but you know you can invest in the market, still not knowing where it is going. So you have some information but not what you normally would expect.
The analysts that acted like they knew something were just guessing because they, like everyone else, were operating in that same 50-50 environment.
Before I ramble further, there are a couple of things I need to make clear about my theory. First, the notion that there is always someone who knows more than we do and the markets are rigged against the individual investor is not totally true. The markets on short term, mid term or long term basis are not rigged at all. With the availability of information online and some tedious research, you will know as much as any of the big boys. They may have six ivy league interns doing backbreaking work researching a particular company but there is little chance they will see anything that you can’t see. They have no intuition so they are going online, just like you and crunching numbers. No advantage, period. Markets on an intra day basis are different. If you are playing day trader, you are at a disadvantage and you are being consistently taken advantage of by high frequency traders and algorithms that will rob and pillage your order before you even know what happened. Sorry. It is true. That has nothing to do with my theory whatsoever. Second, Your ability to see or know 80% of the available information about a particular company or sector is predicated on your willingness to dig deep. That being said, knowing that 80% of the information is out there, you will have to cull the information down to a manageable size and go from there. In other words, the 80% is always attainable, it’s just may not be totally worth it to have it. The 20% is that intangible that the smartest do not or can not see. The things that pop up without warning. The failed drug test of your chief technology officer, a major fire at your biggest production facility. Stuff happens, that why companies have insurance. It is the unforeseen that keeps us on our toes. Thirdly, don’t nitpick about the ratio. If you think you have 85% of what is needed, knock yourself out. 75%? Same thing. I pick 80-20 because it works for me. 80-20 is an acceptable theoretical ration in any number of different instances. For example: Few business managers will argue with 80% of a firms revenue comes from 20% of your accounts. That may not work in every instance but I would venture to guess it works with 80% of the businesses out there.
The key to actually using this to invest is to look at an idea objectively. What do we know about this idea? Is the information out there somewhere? Is there a question as to how much information that is out there is accurate and unbiased? Come up with answers and then decide where this idea sits on the knowledge spectrum. If it comfortably in the 80-20 ratio, the facts are there and you can then make an investment decision. If its 50-50 known to unknown, is that a risk worth taking? Anything below that, stay away. Remember, just because you feel you have enough information, doesn’t guarantee success. Interpreting that information is important and that interpretation is the key to a successful investment decision.
I would love to hear what you think of this theory. So feel free to reach out to me.