The 90/10 Rule

By Al Levit (alanl@ix.netcom.com)

GLENDALE, CA (Feb. 11, 1999) -- When I started out in business consulting, one of the first things I learned about was the 80/20 rule. This rule comes in a variety of flavors, and a frequent exercise is to see how many more 80/20 rules someone can think of on the spot. Common examples of the 80/20 rule are:

  • The salesman who finds that 80% of his sales come from 20% of his customers;
  • The portfolio manager that finds that 80% of her gains comes from 20% of her holdings; or
  • The teacher who finds that 80% of the trouble in her class comes from 20% of her students.

In all cases, the idea is the same. There is a small portion of the whole that needs our concentration, because this is where the outsize returns are likely to be. As the third example illustrates, those outsize returns can go either way.

As I was reading through the RuleBook (a.k.a. Rule Breakers, Rule Makers) in my weekend in the snow, I started thinking about the 80/20 rule. I happened to start reading in the middle, because I felt a "professional need" to be up-to-date on the Rule Maker theory as soon as possible. As a result, I quickly came upon Tom's feeling that a balanced portfolio would have 8 to 10 Rule Maker stocks and 1 or 2 Rule Breakers in it. This was yet another 80/20 rule (or maybe a 90/10 rule). As I continued to read, and think, I found still more.

One of the things I thought about was that Rule Making investing, once you've got it started, can get fairly mundane. In fact, this was part of the original idea. We put some time in at the beginning to select our companies, but having selected them all we have to do is keep tabs on them for 15-20 minutes every quarter. We might get to pick a new company in a few days, but then again we might just buy more stock in one of the companies we already own.

On the other hand, Rule Breaking companies are, to use David's word, sexy. It can be a lot more fun to follow American Online (NYSE: AOL), @Home (Nasdaq: ATHM), or Amazon.com (Nasdaq: AMZN) than to debate what happened in week whatever of the Microsoft (Nasdaq: MSFT) trial. Of course, part of what makes these stocks so much fun to follow is that they often go up so quickly. They are not as much fun to follow when they drop, and as I've noted before, stocks always fall faster and harder than they rise (fortunately, they tend to rise more frequently than they fall, especially the five I just mentioned).

In addition, Rule Breakers take a lot more constant following to make sure that things aren't going haywire. You'll probably be spending a lot more time following these companies. Maybe 15-20 minutes a week, maybe 15-20 minutes a day, maybe 15-20 an hour... who knows?

So what do you do if you want to balance your portfolio between RMs and RBs as Tom suggests? We haven't written a lot about this yet. At least at this point, the principal aim of the Rule Maker portfolio has been to demonstrate Rule Maker investing principles. Another goal, and one we've been quite successful at so far, has been to beat our benchmark of the S&P 500 including dividends. We've also put together a portfolio that requires very little maintenance, which will result in paying very little capital gains taxes.

Last, but certainly not least, our portfolio does not fluctuate nearly as much as the Risk Breaker (er, I mean Rule Breaker) portfolio. For some people, the relative stability of the Rule Maker portfolio doesn't mean much, especially since they would expect that the Rule Breaker portfolio have a higher expected return to compensate for the increased variability. However, there are quite a few people in my group who would DEMAND A MUCH HIGHER RETURN from the Rule Breaker portfolio to compensate for this extra risk. Interestingly enough, January 1999 was a great month to see both the extra risk and the extra reward possible with the Rule Breaker portfolio. We still seem to be seeing some more of that extra risk this week.

The real issue, then, is where this leaves me and you as an investor, especially if we want to throw a few RBs into our RM portfolio. Personally, my level of risk tolerance leaves me with a series of 90/10 rules:

  • When I purchase new stocks, I'll probably look to make the total portfolio something like 90% Rule Makers and 10% Rule Breakers. Please note that I'm not suggesting selling off Rule Makers to make room for Rule Breakers. I hate to pay capital gains taxes. There should be plenty of time to add new Rule Breakers as time goes on.
  • When I go to a party and I'm talking about investments, I'll probably spend 90% of my time talking about the Rule Breakers in my portfolio. I won't mention, unless asked, what a small portion of the total they are.
  • I'll spend 90% of my research time on Rule Breakers, and 10% on Rule Makers.
  • I'll earn 90% of my gains from Rule Makers and 10% from Rule Breakers (I may have to "cheat" on this one to make it come true. If I buy a RB like AOL that becomes an RM, than the gains as a RM count as RM gains).

Tomorrow, I'll finish off the week with some comments about some of the mistakes that we Rule Maker managers have made. Until then, Fool on,


02/11/99 Close

Stock  Change    Bid
AXP   +4 1/4   101.00
CHV   +  9/16  79.19
CSCO  +6 5/16  104.88
KO    +  3/4   64.38
GPS   +1 3/8   63.00
EK    -  1/16  65.81
XON   -2 1/8   70.44
GM    +1       85.75
INTC  +4 7/16  133.25
MSFT  +2 1/8   162.75
PFE   +5 3/8   132.25
SGP   +  7/8   54.31
TROW  +1 5/16  32.69
                   Day   Month    Year  History
        R-MAKER  +2.38%  -2.66%   5.54%  33.54%
        S&P:     +2.49%  -2.00%   2.34%  26.66%
        NASDAQ:  +4.16%  -4.00%   9.71%  45.54%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   24 Microsoft     78.27    162.75   107.94%
    5/1/98   55 Gap Inc.      34.37     63.00    83.30%
   6/23/98   34 Cisco Syst    58.41    104.88    79.55%
    2/3/98   22 Pfizer        82.30    132.25    60.69%
   2/13/98   22 Intel         84.67    133.25    57.37%
   8/21/98   44 Schering-P    47.99     54.31    13.17%
    2/6/98   56 T. Rowe Pr    33.67     32.69    -2.93%
   5/26/98   18 AmExpress    104.07    101.00    -2.95%
   2/27/98   27 Coca-Cola     69.11     64.38    -6.85%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo    72.41     85.75    18.43%
   3/12/98   20 Exxon         64.34     70.44     9.49%
   3/12/98   20 Eastman Ko    63.15     65.81     4.22%
   3/12/98   15 Chevron       83.34     79.19    -4.99%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   24 Microsoft   1878.45   3906.00  $2027.55
   6/23/98   34 Cisco Syst  1985.95   3565.75  $1579.80
    5/1/98   55 Gap Inc.    1890.33   3465.00  $1574.67
    2/3/98   22 Pfizer      1810.58   2909.50  $1098.92
   2/13/98   22 Intel       1862.83   2931.50  $1068.67
   8/21/98   44 Schering-P   2111.7   2389.75   $278.05
   5/26/98   18 AmExpress   1873.20   1818.00   -$55.20
    2/6/98   56 T. Rowe Pr  1885.70   1830.50   -$55.20
   2/27/98   27 Coca-Cola   1865.89   1738.13  -$127.77

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   17 General Mo  1230.89   1457.75   $226.86
   3/12/98   20 Exxon       1286.70   1408.75   $122.05
   3/12/98   20 Eastman Ko  1262.95   1316.25    $53.30
   3/12/98   15 Chevron     1250.14   1187.81   -$62.33

                              CASH   $2205.98
                             TOTAL  $32130.67

Added $ 2,000 on August 4, 1998 to the portfolio; this will show in the numbers at a later date.

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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