Using Pareto Principle to Improve Personal Finance

By Pinyo, 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.

Expenses and Pareto

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.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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20 Comments

FinanceAndFat
November 27, 2007, 7:49

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.
Lauren
November 27, 2007, 14:39

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.
bogart
November 27, 2007, 11:59

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!
debtdieter
November 27, 2007, 12:18

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!
Pinyo
November 27, 2007, 12:43

@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.
eric
November 27, 2007, 16:20

This is new to me. What does the blue line in your graph represent?
Pinyo
November 27, 2007, 17:31

@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.
Joseph Sangl
November 27, 2007, 18:20

I LOVE the Pareto Principle!
Money Blue Book
November 27, 2007, 23:54

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
Pinyo
November 28, 2007, 5:32

@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.
Matt Wolfe
November 28, 2007, 9:05

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.
justo
November 28, 2007, 12:11

great post! can you apply this to the attention economy and creating an attention budget?
Pinyo
November 28, 2007, 17:37

@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.
fathersez
December 1, 2007, 21:46

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
moneymonk
December 5, 2007, 14:58

I love the Pareto Chart!!
Minimum Wage
December 6, 2007, 1:50

Where I work, 20% of the people who walk in the door cause 80% of the problems.
Pinyo
December 6, 2007, 7:46

@Fathersez – You’re welcome

@Moneymonk – Yeah, I think it’s one of the coolest tool, and easy to use too.

@Minimum Wage –
Make Friends, Earn Money
February 16, 2008, 7:57

The Pareto Principle is so versatile it can be used in virtually any situation and usually 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 budgeting (although its more practical rather than theoretical)
grumpy
July 24, 2008, 21:25

My rent is more than 50% of my income, but I don’t know how to reduce it.
Suresh
August 3, 2008, 16:34

Excellent Post.

This is an application of the pareto principle that I hadn’t considered before. Will use it from now. Thanks for that

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