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.
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*.
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:
- Review: The 80/20 Principle at The Simple Dollar
- Pareto’s Law: The 80/20 Principle at Smart Money Daily
- Book Review: The 4-Hour Workweek at Get Rich Slowly
- Twenty Unique Ways to Use the 80/20 Rule Today at Scott H Young
Try it and let me know what you think.
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.