Invest.net

The Pareto Principle and The Capital Paradox

During times of irrational exuberance in a given growth segment, investors tend to throw standard investment due diligence and filtration out the window thinking logically, “this market is in such a growth phase that 10% of these deals are likely to yield wildly…someday.” There is a paradox in investing and life. It is this, 20% of the input accounts for 80% of the output. This can be applied to time, revenue, cost, human resources and–in our case–investing. In what is often referred to as the Pareto Principle (named for economist Vilfredo Pareto), there is a juxtaposed dynamic between inputs and outputs.

We are all guilty

Each of us in guilty of spending too much time on things that matter least. In a more social realm, time spent with family is often sacrificed for things that have a much lower overall return on investment. Capital is more than just money, afterall. In business, we often tend to spread out our time equally across all clients and opportunities, ignoring the fact that 20% of our clients are producing 80%+ of our output. In addition, a return should also be judged holistically. That is,

If I apply this principle to M&A or raising capital, we often spend time with clients in B-level companies with B-level management and a B-level deal (or less), when–in reality–we should be focusing our time on A-grade clients w/A-grade deals. From an investor perspective, we would like to convince ourselves that it is prudent to invest in a diversified manner (even in private placements for accredited investors) across a large number of investments. However, the truly

Are you smart enough to pick the winners from the losers? Even if you were smart enough, the information asymmetry between you and the company issuer is still likely not going to be enough knowledge to bridge the gap. And, even if you do understand and know as much as an issuer does, it is not likely you will ever account for exogenous macro factors that could have an even greater impact on the success of the business over time.

Picking winners and losers is often referred to as a losers game, even for those who can bridge the knowledge gap. Some would argue that in many cases, the way to truly control one’s destiny is to have control. This is where private equity made such a smash killing in the 1980’s and 90’s as they were able to better majority buy-in to companies that fit the 80/20 Pareto rule where they could more easily control the outcomes.

The Capital Commodity

Treating capital, time, knowledge and overall invested input like the limited commodities they are is likely to change the way you see returns in your portfolio and your life. Spending time on the 20% is a test of both discipline and foresight. It also requires one to sacrifice potentially lucrative deals where other qualitative assessments may create the risk potential that, when properly weighted, induces an ROI that is not in-line with the internal goals. The paradox most greatly occurs when we think that more hustle among the 80% will extract greater results. While a business to scale to and service the 80% can be built (see Amazon), most businesses in the services sector have to run the internal check to gauge where their time is best spent.

 

Nate Nead
Latest posts by Nate Nead (see all)