I’m always curious about doing different forms of analysis on my investment data to gather new insights. Not all the inferences might be correct, but some of them are truly compelling and helps me change investing tracks which I may not have paid a lot of attention to in the past. One of the interesting theories is the Pareto Principle, also called the 80/20 rule. It essentially states that roughly 80% of outcomes come from 20% of causes (“the vital few”). This is not a universal rule, but rather an observation that the consequences of cause or efforts are not evenly distributed. This observation can be made in various walks of life, from workplace efficiency to many other business situations.
Over the years as I tracked my money investments, I always found a non-linear correlation between where I put in effort, my brain and money, and where the positive outcome is coming out from. Linear correlations give deterministic results. So when this relationship gets distorted, you start doubting your choices. When I came to learn about Pareto’s Principle, I thought of validating this observation in my investment patterns. It gave me some insights which at least provided some trigger to shake up my one-track stuck investing flow, and prepare better for future.
This post would be more relevant to the audience who invest directly in stocks (equities) because I will be talking about individual stock pick distributions. I will show some real data from my portfolio and how surprisingly close they align with Pareto’s Rule. In the end, I have shared some of my inferences on investing decisions. You do not need any advanced tool to do this analysis. All the data is exported from my Zerodha brokerage account and crunched in Microsoft Excel. So let’s get started!
To fetch the data, I went to https://console.zerodha.com/reports/pnl and exported the Unrealised P&L (profit ‘n loss) report since the start of 2022.
Once the data is exported, all you need are the “Buy Value” and “Unrealised P&L” columns for the rest of the analysis. I created 2 new calculated column fields for each stock row
- % of Portfolio = Buy Value / Total Buy Value of all Stocks
- % of Total Gain = Unrealised P&L / Total Unrealised P&L of all Stocks
I sorted the table based on % of Total Gain column and created a bar chart (Menu -> Insert -> Chart -> Bar)
Chart Explanation: Each bar represents one stock (I have a total of 52 stocks in my portfolio). The bar length represents how much % of P&L this stock contributed to my total P&L. (positive means Profit, and Negative bar indicates loss). For example, the gains from Stock 1 contribute to more than 12% of the entire portfolio gains, and likewise.
Do not confuse this metric with the % return on investment on that stock. For example, Stock 1 could be currently giving me 70% profit (say) on the amount invested, but that’s not directly relevant anywhere in this particular analysis.
Now I have a chart derived (similar Menu -> Insert -> Chart -> Bar) that shows the % of Portfolio (the second calculated column) distribution, on the same table sort order as above i.e. % of Total Gain column.
Chart Explanation: The bar length denotes the invested principal amount percentage, not the current value of that stock. So, if my total investment portfolio is INR 100.00, I have INR 2.00 invested in Stock 1. And this Stock 1 contributed to more than 12% of overall profits in my portfolio (in chart 1). This second chart also indicates I have rarely gone over 3% on any single stock (most of the bars are shorter than that).
Now, we get to the real part. I derived a Pareto Line on the above second chart to see this distribution of investment in ranges. And yes, Excel has an inbuilt chart feature to do it! Just did Menu -> Insert -> Chart -> Pareto on the same “% of Portfolio” column.
Chart Explanation: Each bar shows the number of stocks (left y-axis) in a certain contribution range (x-axis). Most of my stocks contribute less than 2.5% of my overall portfolio, 41 to be exact (21 and 20 from the first 2 columns). The orange line (with its value on the right y-axis) is the Pareto line which takes the cumulative values (from left to right) of the contribution % of each bar. For example, the second Pareto line point (on top of bar 2) is close to 80% which is nothing but the cumulative addition of 21 (bar1) + 20 (bar2) i.e. 41 out of 52 stocks. Hence, it’s understandable the line will reach 100 at its rightmost point.
So hopefully you are with me so far? 🙂 Because I have the final chart with everything superimposed that reveals all the insights in one view. The following chart is derived by selecting both the “% of Total Gain” and “% of Portfolio” columns and generating Menu -> Insert -> Chart -> Pareto
Chart Explanation: Each bar represents the number of stocks (left y-axis) that contribute in a certain gain % range (x-axis). So the first bar says, 21 stocks have contributed to profit in the range [-2.0% – 0.8%]. The low bars towards the right (the last 4 bars) indicate that very few stocks have contributed heavily to overall profits, in the range [of 3.6% to 14.8% of overall profits]
Summarizing these data in a short table –
My portfolio gains have an uncanny resemblance with the Pareto Principle! I tried this experiment on a different investment range (~ 3 years), and the pattern was still quite close to this.
What can I infer from this “Pareto distribution”?
- I do not seem to have strong convictions about my top-performing stocks. Over time, I perhaps had the opportunity but did not build up more positions on them.
- Diversification should be done, but having a common limit for all stocks is spreading too thin on the portfolio. For example, as the second or third chart indicates, I have very less stocks that have more than 3-4% exposure of my total portfolio. So I’m perhaps playing it too safe in the name of diversification.
- There are of course risks associated with heavily investing in few stocks. For example, if you observe the first and second charts closely, Stock 51 is heavily invested in my portfolio, but is giving me negative returns still. By the way, drop a comment if you can guess what that stock would be ?! 🙂 It is a very strong stock (HINT: in the retail sector), and I’m quite confident it will yield good profits in the long term.
Trivia
This is a well-known chart of how Warren Buffet has the Berkshire Hathaway portfolio on top stocks. Last I searched online, Berkshire Hathaway comprises around 50 stocks in its $330bn portfolio. So the top 10 stocks i.e. 20% of the portfolio are surely giving solid returns! The Pareto rule coming to play here surely.
If you find this analysis interesting, do run this through with your portfolio and see how you stand in terms of diversification. You can perhaps use this as a regular health check of stock distribution (I wouldn’t recommend doing it frequently since you need to bet on your stocks for the mid-term at least) and think of rebalancing.
Leave me a comment if you find any interesting patterns in your portfolio!
