UPDATED: What you don’t know about the 80/20 Rule…

Screen shot 2013-05-25 at 2.58.19 PM[ I keep coming across reasons to dig up this old post, most recently here and here on Google+. And before that a Video post by Ze Frank via my Google+ buddy and futurist, Steve Faktor. Also this great post: Pay attention to power law distributions.

And none other than Paul Graham, of proto-startup-incubator Y-Combinator fame, can’t stop talking about it in regards to #Startup Investing, e.g. here how Angel or Early-Stage Seed investments are like “Black Swan Farming”:

the huge scale of the successes means we can afford to spread our net very widely. The big winners could generate 10,000x returns. That means for each big winner we could pick a thousand companies that returned nothing and still end up 10x ahead.
If we ever got to the point where 100% of the startups we funded were able to raise money after Demo Day, it would almost certainly mean we were being too conservative. [4]
We can afford to take at least 10x as much risk as Demo Day investors. And since risk is usually proportionate to reward, if you can afford to take more risk you should. What would it mean to take 10x more risk than Demo Day investors? We’d have to be willing to fund 10x more startups than they would. Which means that even if we’re generous to ourselves and assume that YC can on average triple a startup’s expected value, we’d be taking the right amount of risk if only 30% of the startups were able to raise significant funding after Demo Day.
I don’t know what fraction of them currently raise more after Demo Day. …But the percentage is certainly way over 30%. And frankly the thought of a 30% success rate at fundraising makes my stomach clench. A Demo Day where only 30% of the startups were fundable would be a shambles. Everyone would agree that YC had jumped the shark. We ourselves would feel that YC had jumped the shark. And yet we’d all be wrong.
For better or worse that’s never going to be more than a thought experiment. We could never stand it. How about that for counterintuitive? I can lay out what I know to be the right thing to do, and still not do it. I can make up all sorts of plausible justifications. It would hurt YC’s brand (at least among the innumerate) if we invested in huge numbers of risky startups that flamed out. It might dilute the value of the alumni network. Perhaps most convincingly, it would be demoralizing for us to be up to our chins in failure all the time. But I know the real reason we’re so conservative is that we just haven’t assimilated the fact of 1000x variation in returns.”

“…The big winners could generate 10,000x returns. That means for each big winner we could pick a thousand companies that returned nothing and still end up 10x ahead.

[So]… We can afford to take at least 10x as much risk as Demo Day [presentations of the most recent batch of 50 odd YC startups; YC funds them for a 3 months at ~ $20k up to that point;] investors. And since risk is usually proportionate to reward, if you can afford to take more risk you should.

What would it mean to take 10x more risk than Demo Day investors? We’d have to be willing to fund 10x more startups than they would. …we’d be taking the right amount of risk if only 30% of the startups were able to raise significant funding after Demo Day.

And frankly the thought of a 30% success rate at fundraising makes my stomach clench. A Demo Day where only 30% of the startups were fundable would be a shambles. Everyone would agree that YC had jumped the shark. We ourselves would feel that YC had jumped the shark. And yet we’d all be wrong.

For better or worse that’s never going to be more than a thought experiment. We could never stand it. How about that for counterintuitive? I can lay out what I know to be the right thing to do, and still not do it.

…Perhaps most convincingly, it would be demoralizing for us to be up to our chins in failure all the time. But I know the real reason we’re so conservative is that we just haven’t assimilated the fact of 1,000x variation in returns.”

Some causes have wildly disproportionate effects... Basically, Pareto’s Rule is everywhwere, and applies in nearly all contexts, even though it’s easy to forget about or disregard it 80% of the time… Ha! ]

— REPRINT with updates and addenda:

The 80/20 Rule, or 80/20 Principle, or Pareto’s Law (or Rule), or “law of the vital few”, or law of factor sparsity, or any of the other names that this idea has been named, is often quoted, yet little understood when it comes to really thinking about it and applying it in depth.

Just for some light examples: 20% of the carpets in your house will receive 80% of the wear (this is probably the most quoted), 20% of your friends will drink 80% of your booze, 20% of people on Match.com will go on 80% of the dates, and so forth. The imbalance of input to output that the principle predicts holds surprisingly well across pretty much all contexts.

By the way, here is the first important thing to get about the 80/20 rule: The exact ratio of the imbalance could be more or less than 80% [is “caused” by] 20%, the point is that there will be a distinct imbalance away from 50/50. Most often it seems to range from about 65/35 up to 95/5, and overall it averages out very conveniently around 80/20.

Richard Koch has written a number of seminal books about it, and if you haven’t at least read his “The 80/20 Principle”, you really should get started soon.

More recently, it was brought to people’s attention in Timothy Ferriss’ book “The 4-hour Workweek” during his PR blitz through a number of major internet marketing players’ virtual interview rooms. Continue reading “UPDATED: What you don’t know about the 80/20 Rule…”