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Using The Pareto Principle to Improve Your Finances

Using The Pareto Principle to Improve Your Finances

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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 show you how to use the Pareto Principle to improve your finances.

Expenses and Pareto

The graph above shows my semi-accurate household expenses in percentages using categories I chose (you can express this in dollar amount and have different categories…it is your choice!). 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.

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 a good 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%). In other words, if I manage to shave off 10% from each categories, my dollar saved is highest in the top 2-3 categories.

Based on the example above, I can draft an expense 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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FinanceAndFat
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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
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Lauren

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
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bogart

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!

eric
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eric

This is new to me. What does the blue line in your graph represent?

Joseph Sangl
Guest

I LOVE the Pareto Principle!

Raymond
Guest

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

Matt Wolfe
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Matt Wolfe

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
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justo

great post! can you apply this to the attention economy and creating an attention budget?

fathersez
Guest

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
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moneymonk

I love the Pareto Chart!!

Minimum Wage
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Minimum Wage

Where I work, 20% of the people who walk in the door cause 80% of the problems.

Jonathan
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Jonathan

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
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grumpy

My rent is more than 50% of my income, but I don’t know how to reduce it.

Suresh
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Suresh

Excellent Post.

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

Sarah @ enrichmentality
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Sarah @ enrichmentality

Pinyo, thanks for sharing this post. I think the Pareto Principle is really powerful! I especially agree with your final statement though, that while it’s a great way to prioritise where to start, it’s no excuse to ignore the smaller amounts. Thanks again for your great post and really useful diagnostic tool!

Using The Pareto Principle to Improve Your Finances

by Pinyo time to read: 2 min
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