Using Pareto Principle to Improve Personal Finance
, on November 27, 2007
The 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:
Try it and let me know what you think.
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About the AuthorPinyo
is the owner of Moolanomy Personal Finance
and an entrepreneur with over 20 years of business experience. He has a strong appreciation for business management, investing, and wealth building. He has written for many online publications, including American Express and U.S. News.
The information on this site is strictly the author's opinion. It does NOT constitute financial, legal, or other advice of any kind. You should consult with a certified adviser for advice to your specific circumstances.
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