Using Pareto Principle to Improve Personal Finance
By Pinyo • Nov 27th, 2007 • Category: Financial PlanningThe Pareto Principle, also known as the 80-20 rule or the law of the vital few, is an observation that 80% of the effects come from 20% of the causes. I often use the Pareto Principle in my job, especially when we work on quality or process improvement projects. A nice thing about Pareto is that we can apply it to almost anything. Today, I will demonstrate how to use the Pareto Principle to improve our finances.
The graph above shows my semi-accurate household expenses in percentages based on the way I categorized them. If you are disciplined about budgeting, you will have this number handy, and can create a similar graph based on your categories. Unlike, typical budget numbers, this graph is organized from the highest to the lowest category.
Visual Revelation About My Finances
Immediately, the graph (also known as the Pareto Chart) says something about my priorities and value. For instance,
- I am a saver. I save more than 13% of my income toward retirement — compares to the U.S. Personal Saving Rate of sub 1% (source: Bureau of Economic Analysis), I am an extraordinary saver.
- My housing cost which includes Principal, Interest, Taxes, and Insurance (PITI) of 19% is in the safe zone, compared to the 28% generally recognized maximum.
- There’s probably something I can do to reduce expenses on entertainment, food, and car. They seem rather high in the list.
Applying The Pareto Principle To Reduce Expenses
If I want to reduce my expenses, I will get the best result by focusing on the first few categories*. Why? Let assume that each year, I pay $17,000 in taxes and $8,000 in car expenses. If I need to cut $500 from my expenses, it’s easier to shave $500 off $17,000 (2.9%), as opposed to $500 off $8,000 (6.3%).
Based on the example above, I can draft my expenses reduction plan as follow (excluding mortgage and retirement savings):
- Reduce taxes using some of these taxes reduction ideas.
- Review my food, entertainment, and car expenses to more thoroughly identify where I can cut expenses — i.e., use the Pareto Principle within that category. My guesses are:
- Food/Entertainment - eat out less, bring my own lunch to work, lower vacation budget, etc.
- Car - drive less, use public transportation, sell the second car, etc.
* However, Pareto isn’t an excuse to ignore other expenses. It is a great way to prioritize where to focus when we have limited resources — i.e., time, money, energy, etc.
More about the Pareto Principle:
- Review: The 80/20 Principle @ The Simple Dollar
- Pareto’s Law: The 80/20 Principle @ Smart Money Daily
- Book Review: The 4-Hour Workweek @ Get Rich Slowly
- Twenty Unique Ways to Use the 80/20 Rule Today @ Scott H Young
- Apply the 80/20 Rule with “The Crowbar” @ Genius Types
- The 100 Year Old Golden Rule @ How I Will Be Rich
Try it and let me know what you think.
This post was featured in:
- The Carnival of Personal Finance #129 hosted by Cash Money Life. For more information please visit the Carnival of Personal Finance.
Great post! That is an application of the pareto principle that I hadn’t considered before, though it seems so intuitive now when I see it.
I have not arranged a pretty graph yet, but I do include a percentage calculation on each category of my budget. I will have to take a look and see if I can’t trim some of the fat.
Yes, I find this sort of approach helpful also. While there are other important reasons for conserving water in the SE US where I live, I am always amused by the exhortations that urge me to SAVE WATER TO SAVE MONEY! If I cut my water usage by 50% (unlikely), I would save $15/month. There are other, much easier ways (things I would have to cut back much less than 50%) to save $15/month!
That said, I am trying to watch my water usage for environmental reasons!
I confess I had to read this post twice before I got what you were talking about, but it makes so much sense now. Great post!
@FinanceAndFat - thank you. Once you have your graph put together, I would love to see a post about it on your blog.
@bogart - welcome to Moolanomy. You got it. Also, good point about not letting money become the only criteria. I am with you 100% on trying to save the environment.
@debtdieter - welcome to Moolanomy and thank you. If there’s anything I need to clarify, please let me know.
This is a great post and so very true. This is a principle that can be applied to so many different things in life and its great to see it when applied to the personal finance aspects.
This is new to me. What does the blue line in your graph represent?
@Lauren - thank you and welcome back!
@Eric - welcome to Moolanomy. I wasn’t so clear. The percentages on the left represents the height of the bar graph. The percentages on the right and the blue line represents cumulative percentages — i.e., taxes plus mortgage total about 32%, add retirement savings and it add up to about 50%, etc. So you can see that the first 6 categories represent about 80% of my expenses.
I LOVE the Pareto Principle!
Interesting concept…so is it suggesting that I would be better of not trying to save money giving up drinking Caribou Coffee and bottled water and instead focus on big ticket items like rent and car payments?
-Raymond
@Joseph - hi, thanks for stopping by.
@Raymond - no, that’s not what it’s suggesting. It basically said if you have limited time and resources, then focus n the big ticket items first and leave the small stuff for last. Similar to the old saying: “Don’t sweat the small stuff.”
Now there’s another concept called Quick Win. It’s easier to stop drinking coffee and bottled water, than implement a home improvement that will cut your energy bill by 20%. Therefore, you should go ahead and stop drinking coffee and bottled water just because you can capture that saving very fast and with little effort.
Thanks a lot for posting my link. I’ve always loved this rule. I don’t think a week goes by in my company where the topic doesn’t come up in some sort of meeting here at my company. It applies to so many things in life as well and if you consciously focus on the principle in other facets of your life, you will realize how much truth it holds in everything you do.
great post! can you apply this to the attention economy and creating an attention budget?
@Matt - no problem!
@justo - I didn’t know what Attention Economy was and had to look it up. But I think you could, since we are also dealing with scarcity of resource, namely attention. For example, a lot of people tend to scan when they read online. Therefore, you have to make your headings effective. In essence, the headings (20% of the content) are doing 80% of the work.
As for “attention budget,” I have no idea what that is.
This is a great idea.
We have just down our first family budget (after 23 years of marriage and 5 children!).
We’ll apply this principle and find out where we should focus.
Thanks
I love the Pareto Chart!!
Where I work, 20% of the people who walk in the door cause 80% of the problems.
@Fathersez - You’re welcome
@Moneymonk - Yeah, I think it’s one of the coolest tool, and easy to use too.
@Minimum Wage -
The Pareto Principle is so versaile it can be used in virtully any situation and useually holds true. It’s a great analysis tool and whilst it can’t solve your problems for you it can at least point out where you should start. I’m impressed with the 13% of your income that you are managing to convert into savings, mine’s about 5-6%, nice job pinyo, great post and as ever really helpful illustrations, it just makes it so much more user friendly. I’ve also written a post on the various aspects of budgetting (although its more practical rather than theoretical) http://www.friendsandmoney.co......eting.html
My rent is more than 50% of my income, but I don’t know how to reduce it.
Excellent Post.
This is an application of the pareto principle that I hadn’t considered before. Will use it from now. Thanks for that