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.
For example:
- 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%
Why?
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.
Bottom Line
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.
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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®.
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!
@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.
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.
@Lauren – thank you and welcome back!
I LOVE the Pareto Principle!
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
@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… Read more »
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.
great post! can you apply this to the attention economy and creating an attention budget?
@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.
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
I love the Pareto Chart!!
Where I work, 20% of the people who walk in the door cause 80% of the problems.
@Fathersez – You’re welcome 🙂
@Moneymonk – Yeah, I think it’s one of the coolest tool, and easy to use too.
@Minimum Wage – 🙂
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)
My rent is more than 50% of my income, but I don’t know how to reduce it.
Excellent Post.
This is an application of the pareto principle that I hadn’t considered before. Will use it from now. Thanks for that
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!
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.