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, primarily when we work on quality or process improvement projects. A beautiful 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 a rough approximation of my categorized household expenses in percentages.
To follow along, you can set up your budget and list out the most expensive category to the least expensive. You can do it in dollar amount or use percentages. You can also group them in different categories. It is all your choice!
You can also try online tools, such as Personal Capital, which will help you visualize your expenses automatically.
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.
What 80/20 Rule Revealed About My Finances
The graph (also known as the Pareto Chart) shows that 80% of my expenses are in just six categories. These are the six categories where I want to start making adjustments to improve my finances.
- Mortgages – Is there any opportunity to reduce my mortgage payments? Maybe refinancing my mortgage? What about downsizing? In general, you want to keep your total home-related expenses under 25% — so I can make some improvements here.
- Taxes – This is usually the biggest or second-biggest category. However, this might not show up in your budget because most people start with their take-home pay and do not include deductions and withholdings in their budget. Since I am self-employed and also own my own businesses, my budget keeps track of gross income and shows taxes.
- Retirement Savings – Technically, saving for retirement is not an expense. But I do recommend you keep track of this in your budget so you can see what percentage of your income goes toward retirement savings. The recommended amount is 15% of your gross income. Again, I have some room to improve here.
- Travel – This is one thing my family spends more than we should on. Also, it is bigger than a typical budget because we usually pay for both sets of parents to travel with us.
- Home Improvements – This has been a rough year for us with several incidents that necessitate HVAC replacement, roof replacement, and reflooring of our flooded basement.
- Child Related – Our son attends public school for free, but there are several extracurricular activities that he is involved in. Maybe it is time to spend less on these activities?
What does your Pareto Chart reveal about your finances?
Applying the Pareto Principle to Reduce Expenses
If you want to start improving your finances, the best place to start is in the few categories that make up your 80%
Let’s assume you spend the same amount of effort and were able to reduce your expenses 10% across the board (which would be terrific).
On the 80% side, you’d realize a net saving of 8% of your total budget, whereas the same 10% on the 20% side only saved you 2%.
Here is another perspective. If your total monthly expense is $5,000 and you need to shave off $500. It would be a much easier task to cut $500 from the 80% side (which is $4,000 in expenses) vs. trying to cut $500 from the 20% side (which is $1,000 in expenses).
Based on the example above, I can put together a plan as follow:
- Mortgages – Evaluate whether refinancing or downsizing would be a good option.
- Taxes – Implement tax reduction ideas, perhaps by contributing more to retirement savings so that we can get more deductions.
- Retirement Savings – Look for opportunities to add more to retirement savings.
- Travel – Spend less money on travel. May be replaced longer and overseas trips with local activities.
- Home Improvements – A lot of the expenses in this category was a one-time thing, and I think this will go back down to the average level for the foreseeable future.
- Child Related – Evaluate and see if there are any unnecessary expenses we can cut here.
* 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.
The 80/20 Rule is a great tool that can be applied to just about anything. If you haven’t considered it before, try using it on your budget and see if you can improve your finances with the Pareto Principle.
Try it and let me know what you think.
Pinyo Bhulipongsanon 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®.