The 80/20 rule, or Pareto principal, is one of the most common management strategies to help people focus on what’s important and get more done. Simply stated in terms of productivity, the 80/20 rule says that 80 percent of results come from just 20 percent of your effort (and, conversely, that 80 percent of your effort affects just 20 percent of your results). Today I ask: How can you apply the 80/20 rule to your personal finances?
The 80/20 Rule And Your Budget. I’m not going to try to propose a model that suggests everybody spends 80 percent of their money in certain areas. Everybody’s budget is different, and any attempts to generalize could be quickly disproven. I will suggest, however, that when we try to trim our budget, we should look at the categories in which we spend the biggest dollar amounts. Those areas are our 80 percent.
(Here’s a hint: Those categories may not be your daily coffee or lunches out—areas in which we’re often told are the easiest places to cut back). Often times, making cuts to those small expenses is not easy. We miss those little indulgences in life. Yet despite our sacrifices, we’re only hacking away at the 20% of our budget. We’re being penny wise and pound foolish.
Now let’s look at the 80 percent. Our big spending categories probably include housing, transportation, and debt (if you have it). So think for a moment: Are there ways you can cut back in these areas? For example:
- Take on a roommate and cut your rent or mortgage in half
- Carpool and cut your gas/tolls/parking in half
- Consolidate or pay off that debt now to lower or eliminate interest
Granted, these steps may be bigger sacrifices than learning to pack a bag lunch (so perhaps the trade off is not precisely 80/20). These steps, however, can result in big monthly savings, fast! I’m not suggesting you should slack off on trimming the fat in your budget anywhere you can find it; but I am reminding you to make sure you’re not ignoring any big, big pieces you could slash off!
The 80/20 Rule And Your Decisions. I read somewhere that “20 percent of your financial decisions results in 80 percent or your financial results”. That makes sense to me: Say you decide to finance the purchase of a new car at a high interest rate for four years rather than continuing to drive you beater and save that money. That’s one decision that could mean a swing of $10,000 (or much more) in your net worth.
The 80/20 Rule And Investing. I think this principal can definitely apply to investing, too—especially for any amateurs trying to trade their way to better returns. When it comes to investing, I think it’s safe to say that 20 percent of the effort you spend on deciding where to invest will yield 80 percent of your returns. And do you know where those returns will come from? Boring old index funds, blue chips, and low-fee mutual funds that track the market. Of course, you can save that extra 80 percent of effort by doing what I’ve always recommended: ignore the market.
What about you? Can you think of other examples of how the 80/20 rule can be applied to personal finances?
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