Did you ever get the feeling that most things in life are not uniformly distributed? If you did then let us tell you that you are not alone. A gentleman by the name of Pareto got a similar feeling when he observed that around 80% of Italy's wealth belonged to only 20% of its population.

Soon, this idea was extended to other disciplines and appeared to have shown the same set of results. Like how 20% of the effort creates 80% of the result. Or how 20% of the customers create 80% of the revenues and so on.

Please bear in mind that the idea is not to have the exact 80/20 relationship in all the cases. In fact, it is just an approximation about how most things seem to be distributed unevenly. And about how not all things contribute equally to an effort, a handful of them contribute much more than the others.

Thus, this rule, over time, came to be known as the Pareto Principle or the 80/20 rule.

Is the Pareto principle applicable in investing too? We do think so. A thorough look at price movements of stocks and other commodities do suggest that some sort of Pareto principle is at work here. We routinely observe that majority of the stock price fluctuations takes place in a very short window of time.

To explain in Pareto terms, nearly 80% of the stock price movements seem to take place in 20% of the time. This is the reason that timing the market seems to be a losing long term proposition. Identifying that portion of the time period where 80% of the stock price movement takes place is indeed difficult.

Thus, the idea is to keep holding the stock if it is undervalued and then wait for the price to go up in Pareto fashion.

A leading financial portal has made some interesting use of the Pareto principle we believe. And that is to identify the price of gold few years down the line. It has asked us to imagine that the current gold bull run which started way back in August 2001 represents 80% of the time period and 20% of the increase in gold price.

It then follows that by August 2015, which would represent the remaining 20% of the time, gold's price could well rule at more than US$ 8,000. This would take the yellow metal more than 5 times higher than the current price.

Gold certainly may or may not go that high by 2015. But there is every possibility that it breaks new price records in the coming years. Plus, improving fundamentals may not be the only reason behind gold price rise.

Once we consider the fact that both buying as well as selling tends to go overboard once a certain trend is established, the possibility of the yellow metal going up substantially within a short time period is certainly on the higher side.

Who knows, the Pareto principle may well turn out to be correct ultimately.


By Equitymaster - India's leading 'independent' equity research initiative. Trusted by over a million members all over the world, Equitymaster is known for its well-researched, unbiased and honest opinions on the Indian stock markets.

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