The Pareto Principle. A decision-making tool.

I’m sure you happened to stumble upon one of the following statements at least once:

• 80% of profits are generated by 20% of your customers
• 80% of revenues are generated by 20% of your products
• 80% of complaints come from 20% of your customers
• 80% of the work done comes from 20% of employees
• 80% of the crashes in your system come from 20% of the bugs
• 80% of healthcare costs come from 20% of the population
• 80% of investment returns come from 20% of asset allocations

and I could go on…

What does it mean? It seems that there is something that links together all these statements even if the contexts are completely different.

The “invisible link” is called the Pareto principle (or 80 20 law).

From Wikipedia: Vilfredo Pareto (15 July 1848 – 19 August 1923) was an Italian civil engineer,  sociologist, economist, political scientist, and philosopher. He made several important contributions to economics, particularly in the study of income distribution and in the analysis of individuals’ choices. ‍

The Pareto principle origins from the empirical observation that 80% of the land in Italy was owned by 20% of the population. After conducting similar studies in other countries, Pareto identified the same pattern over and over again.

The Pareto principle, also known as the 80/20 rule, basically states that there is a non-linearity, an asymmetry between cause and effect, input and output, or effort and result. The Pareto principle fits well in almost any situation where cause and effect are at play.

What is the math behind it?

Well, you might be disappointed to know that the Pareto principle is not a formal mathematical equation. It is more a generalized phenomenon supported by empirical evidence and observed in many different fields. Also, the numbers 80 and 20 are indicative.

The real point of the Pareto principle is that not all inputs are equally important. Only a few of them are detrimental to the final outcome and make a real difference. As a consequence, those few are the ones deserving most of the available resources (where resources can be time, effort, money, etc). In a few words, the Pareto principle is about effective resource allocation.  

Pareto Principle and decision making.

The Pareto principle comes in handy if you need to analyze different options/alternatives, rate them against each other and decide which one to go for.

Here follows the step-wise approach I’ve used a few times in this specific context.

Step 1.

If I had to pick a title for this step, I would definitely go for "Changing perspective" and I hope the reason will be clear soon!

When looking at the available options, we often tend to evaluate each of them by answering questions like:

• how much time will it take?
• how easy/complex will it be?
• how much will it cost?
• how much do I like it?
• how comfortable does it make me feel?
• which is the expected outcome?

As you can see, outcomes are often taken into consideration together with several other parameters.

Some of these parameters (cost, time, complexity, etc.) must definitely be factored in, but at a later stage. Some others are just “information noise” and might pollute our final decision.

To make it even more complicated, the “information noise” affects our judgment more than we can consciously realise because it might trigger our personal feelings/emotions. It takes real effort and discipline to filter it out and focus on what really matters.

So…what if we change our point of view and evaluate the options from the outcome perspective instead?

Should we do so, we would start from a different set of questions like:

• which are the possible outcomes?
• which option generates the highest outcomes?
• which option increases the exposure to the highest outcomes?

Focusing on the outcomes reminds me of the “via negativa” explained by Nassim Nicholas Taleb in the book Antifragile. “Via negativa” is about removing what is not essential and focusing on what matters the most. The outcome is what matters the most.

We are now at the end of the first step and we managed to turn a random set of options into an ordered list prioritised by outcome.

Step 2.

The title I would pick for this step is “Reality check”.‍

Once we finally know the top-of-the-list option, we “only” need to move forward with it but…

…what if we won't have enough resources? or, in other words, what if the option is not viable?

While the main goal of the first step is to narrow down the focus to a few options only, the goal of the second step is about making a reality check and identifying the needed resources.

Now it is time to look back at some of the parameters we deliberately decided to “forget” during the first step. Time, money, effort, etc. can be the limiting factors and are the resources we need to properly assess.

In the best-case scenario, we have everything we need and we can move on with the top-of-the-list option (the one which generates the highest outcomes).

f this is not the case, we have two alternatives. Either we investigate the possibility to make the top-of-the-list option “cheaper” (consuming fewer resources) or we move on to the second-best.

The process goes on until we find the best viable option which is the option generating the highest outcome among the viable ones.

Step 3.

The last piece of our “saga” could have a title like “Go back to the start”.‍

New options always arise and it is vital to assess them against each other and against the ones already available.  

This step is crucial because it fosters an “outcome-based” mindset and a way of reasoning that can be applied to many different contexts.