The combination of the power law distribution and the 80/20 rule (also known as Pareto’s principle) are the fundamental guiding principle of startups, peak performance, and life in general.
The fundamental principle behind the power law distribution is that the majority of results are generated by a minority of the top individuals, leading a small number of people to highly disproportionate results. To illustrate, here are a couple examples.
- 20% of venture capital investments account for nearly all of the gains, meaning two out of every 10 investments should generate at least 30 times the investment.
- 0.4% of startup accelerators account for 67.29% of total exit sums of all startup accelerators.
- High end sports car brands (Lamborghini, Ferrari) are able to charge 10 to 20 times more than other brands.
- The top professionals in any field can make 5 to 10 times more than the other people in their field.
The point is (moral and ethical implications aside), understanding the power law distribution is key to understanding achievement in any area, and explains how getting to the absolute top of your craft can yield massively disproportionate outcomes. This is why the top restaurants, brands, creatives, etc are able to charge 50 to 100 times more than others.
In this post, I’m going to discuss Pareto’s principle and the power law distribution as applied to investing, productivity, and innovation.
The interesting meta-level discussion here is that I don’t claim to be an expert in any of these areas, so the post isn’t about the tactics of achieving a level of disproportionate return in these areas, but simply illustrating how to consider the law of disproportionate returns when applied to areas like this in order to better understand the effects of being a master at your craft.
What in the world are you talking about?
To help you get a better idea of these two principles, I’m going to use an example. Say that you are learning to program with the intent of selling a mobile application without any prior knowledge of programming. When you first begin, you will be at the bottom of the rank of programmers, putting you at 0 percentile. However, as you get better, you’ll quickly advance past the other beginners, and with some decent coaching and focused effort (practicing and studying the right things), you should be able to hit somewhere between 70 to 80 percentile in a matter of months. This is Pareto’s principle in action.
As a result, Pareto’s principle explains why you can get to a relatively high level of proficiency relatively quickly, but advancing further becomes increasingly difficult. It is much harder go from 70 percentile to 90 percentile than it is to go from 0 percentile to 70 percentile.
After reaching about 80 percentile in your abilities as a programmer, however, the mobile application that you are able to create is not generating very much, if any, revenue. For the sake of this example, we’re going to say that the only factor that contributes to the success of a mobile application is how well it is written (There are concrete real-world examples later in this post). Unfortunately, only the people at the very top of the spectrum make the glorious revenues that you were dreaming of when you first started programming. This is the power law distribution in action.
Thus, the two graphs look something like this.
If we graph all the people in a particular field or industry against their ability at a certain skill, we get a graph that looks similar to Pareto’s principle. However, if we graph all the people in a particular field or industry against a measurable external metric of the corresponding person’s success such as money, we get a graph that looks similar to the power law distribution.
Thus, the distinction between Pareto’s principle and the power law distribution is that Pareto’s principle has it’s section of fastest growth at the beginning, while the power law distribution has it’s section of fastest growth at the end.
If you really think into it, you’ll realize that there are certain circumstances that you could explain using Pareto’s principle or the power law distribution. Therefore, what you’ll realize is that Pareto’s principle and the power law distribution are practically the same thing as the graphs are simply mirror images of each other, the only difference is whether the distribution is front heavy or back heavy (depending on how you spin it). I’ve intentionally introduced both of them in order to better illustrate the examples in this post.
Going back to our example of learning to program with the intent of selling a mobile application, what you’ll find is that although it takes relatively minimal effort to become proficient at programming, it takes a disproportionally large amount of effort to actually achieve the end goal of making money via selling a mobile application.
Now onto a couple implementations of these two principles.
For the most part, productivity is a desired ability among almost everyone I meet. I hear people say how much they wish they could be more productive on a regular basis, or how much they wished they could have three more hours to the day.
But even the most successful people only have 24 hours in a day and 7 days a week. All the legendary presidents, entrepreneurs, and revolutionaries work with the same amount of time that you do. How come it seems that some people can achieve so much more with their time?
The key among the most seemingly productive people isn’t that they have some magical ability to do more, but that they understand how to dissect and select the most important tasks to complete. Being able to select the right things to work on is the implementation of Pareto’s principle, while dissecting the characteristics that make the top performers as successful as they are is the implementation of the power law distribution.
By being able to select the right things to work on, you are clarifying the distinction between being busy and being productive. Anyone can fill their day with things to do, making it seem like they are accomplishing a lot. I’ve been guilty of this myself. However, selecting the things that matter the most in your work and your life and doing those things well make the largest difference in the grand scheme of what you are trying to accomplish.
When it comes to selecting and prioritizing things to maximize my productivity, one way to think about it is from the perspective of return on investment. If you’re investing ten hours into accomplishing something, how much is it going to pay off in the long run? Are your efforts going to simply putting out fires or are you building something that will minimize the number of fires that occur?
I’ve written about the difference between managing your energy and managing your time, which is yet another illustration of the value of selecting different aspects of your day to focus on rather than attempting to think of what you are able to do in a linear fashion.
On the flip side, being able to dissect characteristics of the top people allow you to achieve your goals at a disproportionate rate. Productivity is nothing more than a means to some end. Productivity should never be the end in itself, because when productivity is made the goal, you are more often just making yourself busy rather than making yourself productive.
One interesting phenomenon that you’ll notice is that the most successful people in their field often are extremely productive, but not busy. I’ve met many people at the top of their field that have an incredible ability to be present and not rushed.
Thus, by setting your goals for productivity, you are able to then turn around and begin dissecting different parts of your work to determine what generates the biggest returns. By deeply understanding the little nuances of your work, you’re able to optimize at a whole different level.
Therefore, it’s easy to find a quick way to prioritize the things that you do, making yourself more productive, but it’s much more difficult to learn how to apply the productivity in a way that ultimately achieves the goal you’re trying to achieve.
It’s amazing how many people think they are smarter than everyone else investing in stocks. I find that most of the people I talk to think they have the magical ability to buck the trend and become a millionaire by manipulating stock forms on their computer.
But the truth is, few people actually make a significant amount on the stock market. You don’t usually hear about people who lose money through stocks because they generally don’t talk about it.
In this situation, Pareto’s principle is applied to the fact that it is quite easy to learn about stocks, but quite difficult to be extremely successful. Learning about the principles to make a million dollars on the stock market is straightforward, but implementing and following through with those principles are much more difficult.
Beyond investing as expressed in stocks, the other area that has been attractive (and also more interesting for the sake of the power law distribution), has been angel investing and venture capital. Investing in startups follows a similar sort of trend.
Startups are by nature the pinnacle of high risk and high reward method of investing. As a result of this high risk and high reward nature, almost everyone has the aspirations of taking part in the next big thing.
However, being an angel investor or venture capitalist isn’t as glamorous as it seems, especially when studies shows that venture capital as an asset class continues to underperforms the S&P 500.
In the same way as stocks, being able to successfully pick the companies of the future is a challenge that only the top firms are successful at, and even then, it’s mostly serendipitous.
The reason why venture capital is so difficult is because people are making bets in the present based on what they believe the future is going to look like. It’s about being able to identify today the individuals who will be successful in the future.
Companies live and die on the basis of the value they create. A company that is unable to create new value or maintain the value that they have already created generally find themselves in a position where they begin to lose the market that they have previously acquired.
In any company, the most value is created when the team spends their time developing the product. However, even when it comes to developing the product, only a small fraction of the time spent developing the product is used for developing the features that have the highest impact on a product’s success.
For example, most of the Google products that we use on a regular basis such as mail and docs started as side experiments through Google’s notoriously well known “20% time”, in which employees spend working on a product of their choice one day out of every week.
The impetus behind such a program is to allow employees to expand the time they spend solving new problems and challenges that can become the company’s next best asset. This is Pareto’s principle applied to innovation.
However, in the grand scheme of world markets, simply developing a product does not mean that it will be successful. The mantra of “If you build it, will the come?” rarely holds true.
“Every moment in business happens only once. The next Bill Gates will not build an operating system. The next Larry Page or Sergey Brin won’t make a search engine. And the next Mark Zuckerburg won’t create a social network. If you are copying these guys, you aren’t learning from them.” – Peter Thiel (Zero to One)
Imitation is as old as the earth itself. It’s always been easier to make a copy of something that already exists than to create something that doesn’t. Following a plan or going down a checklist doesn’t require any real thinking, because you simply follow the guidelines that someone else has set.
Therefore, when it comes to building a company that is truly innovative and truly valuable, everyone thinks that the successful companies of the future will look like the successful companies of the past, making the few people at the top who are truly innovative to generate disproportionate returns. You can try to analyze successful companies all you want and learn many things from their success, but you’ll never be able to replicate it by doing the exact same thing.
By understanding these two distributions, it becomes easier to identify trends in your everyday life as well as in global phenomena as a whole. It also becomes easier to predict the outcomes of different aspects of your work, as well as what to do in order to generate the best results depending on what your goals are.