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| The 80/20 cycle |
| Mukul Pal / Mumbai Aug 24, 2009, 00:28 IST |
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The 80/20 rule or the Pareto principle though initially used to illustrate wealth allocation is also the power law.
The author of the book 80/20 principle, Richard Koch explains in brief history of the principle how Vilfredo Pareto's (Father of microeconomics) idea became widely know when Joseph Moses Juran, one of the gurus of the quality movement in the twentieth century, renamed it “The rule of the vital few”.
80-20 explained
In his 1951 tome “The quality control handbook”, which became hugely influential in Japan and later in the West, Juran separated the “vital few” from the “trivial many”, showing how problems in quality could be largely eliminated cheaply and quickly, by focusing on the vital few cases of these problems. Thanks to this new attention to quality control, between 1957 and 1989, Japan grew faster than any other industrial economy. 20 per cent of inputs generate 80 per cent of the output. 20 per cent of causes create 80 per cent of consequences. Effort and reward are not linearly related. This is why 20 per cent of effort drives 80 per cent of the results. Does it sound familiar? 80 per cent of stock market capitalisation and trading volume comes from 20 per cent of the stocks. This was the reason indices were created. There was no point focusing on the majority of the stock market listing, if only a few were moving the market. 20 per cent of the time is when excitement (euphoria, fear) hits 80 per cent peaks. 80 per cent of the wealth is owned by 20 per cent of the people. 20 per cent of a company's clients create 80 per cent of the income. Only a part of your portfolio will generate real winners. Only a few clouds create the most rain. Few vegetables are the most nutritious. We now have 80/20 thinking, 80/20 framing system, 80/20 housing, 80/20 initiative etc. This should have lessons for all analysts. 20 per cent of your indicators can do 80 per cent of the job. Over analysis is necessarily not better. What about traders? 80 per cent of trading profits come from 20 per cent of transactions. 80 per cent of trading time is about bad fills and hard work and 20 per cent is the real kill. This is the same thing about strategies. 80 per cent of strategies are old wine in new bottles and noise. Just 20 per cent are the real ideas. Same is with news. 20 per cent news matters, 80 per cent is noise or 20 per cent is quality and rest is quantity.
The 80-20 individual
In his other book, 'the 80/20 individual', Koch talks about the 80/20 individuals causing the revolution that creates the new economy and brings down the old capitalism. A corporate system that still revolves around management hierarchy rather than individuals and a stock exchange that rewards passive investors is weak and redundant. According to the author, in the next two decades, the economy could stop following the old pattern of managerial capitalism and corporations could revolve around their key individuals. When this happens, the economy will change abruptly and radically. We will witness a huge wealth transfer to 80/20 individuals and away from institutions to entrepreneurs and away from savers (people who save money and invest in stock market), a savings account or another financial institution.
This Koch calls as the shift from capitalism to individualism. We agree with a part of the author's argument and prefer working as partners at Orpheus rather than as employer and employees.
However, a part of Koch's debate is weak. He assumes many aspects and does not even mention cyclicality. The road is not about capitalism to Individualism (as Koch reiterates). The two already coexist as two polar parts of the same cycle. Individualism is an offshoot of the system. Koch's 80/20 creative individual is inefficient like the rest if he does not understand cyclicality. Great ideas also need timing of an economic cycle. One can't have brilliant ideas, a generation ahead of its time.
The flaws
Ideas incubate and get accepted in time and like everything unfortunately or fortunately need a market. An idea without a market to value them is not valuable. Open source is a great idea that is commercially viable. Red Hat is a part of S&P500. Koch assumes that markets may come to an end because of the rise of the 80/20 individuals. Individuals create institutions and to see them separately is tough. The author also assumes 80/20 individuals have a complete set of character list.
They are smart individuals who don't have emotional flaws or greed element. The aspect of 80/20 individuals jumping ship, smart companies buying back and going private was always a well exploited opportunity.
What if cash becomes king and stock market becomes unimportant? Here the author fails to realise that stock markets move from cash and sub-cash value to the other extreme cyclically. 80/20 individuals going private can't assume and ignore the visibility the stock market gives, the amount of information it discounts, price discovery etc. Koch's 80/20 individuals are not time cycle literates. They just focus on growth and don't understand that value and growth moves in cycles.
Personality development books are easier to write. Teaching people how to read and interpret time cycles of markets or economy is tougher. The question Koch does not answer is how to teach the 80/20 individual to be in the 20 per cent right time? Why does 80/20 exist in the first place? Is 80/20 a dynamic number or something static? Does 80 per cent change and decrease and 20 per cent change and increase? Sentiment surveys have illustrated how market psychology moves from 80 per cent bulls to 20 per cent bulls. The sentiment of capitalism like an individual's mood is cyclical. Pair performances prove to us that an 80 per cent outperformer can also underperform.
80/20 is beautiful because it's a ratio beyond equality. Proportion is what creates nature. Imagine a tree with perfectly equal leaves. Or think about how a human would look if he had perfectly equal limbs. Would it be interesting? Fractals are 80/20 and like rest of 80/20 ratios, cyclical.
We are so tied to the underlying time and its cyclicality that we just can't shake it off. In a recent article in Scientific American “Do people really walk in circles?” the researcher proved that even though walking in a straight line seems like a very simple thing to do, it's actually very complicated.
The results suggest that without visual or auditory clues, people would only end up travelling a total of 100 meters from their starting point regardless of the time they are given to wander. Amazing isn't it? Search for the article and look at the embedded video. You will be surprised to see how disoriented we are. 80/20 individualism is no fun if we don't know that time fractals and time cycles are the reason why disproportionality of 80/20 exists in the first place. Even a genius can learn a lot from stock markets. The first thing he will lose is the illusion of his genius, as the cycle turns.
The author is CEO, Orpheus.asia, a global alternative research firm
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