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 budget categories. Unlike, typical budget numbers, this graph is organized from the highest to the lowest category.
You can also try online tools, such as Personal Capital, which will help you visualize your expenses automatically.
Immediately, the graph (also known as the Pareto Chart) says something about my priorities and value. For instance,
If I want to reduce my expenses, I will get the best result by focusing on the first few categories*.
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 expense reduction plan as follow (excluding mortgage and retirement savings):
* 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.
Try it and let me know what you think.