Pareto’s Principle (80/20 Rule) of Personal Finance April 7, 2007

Some of you may remember the 80/20 rule or Pareto’s Principle from college or from your work life if your company subscribes to Six Sigma methodology. For those who aren’t, the 80/20 rule was developed by Italian economist Vilfredo Pareto to describe the unequal wealth in his country, observing that 20 percent of the people owned 80 percent of the wealth. Similar observations were made by others in other areas such as Quality Management (the vital few and trivial many).

The 80/20 Rule means that only a few things are vital (20 percent) and the remaining are trivial (80 percent). You have probably seen many examples of this in business where 80% of a given problem are only caused by a few things…or 80% of your company’s sales may be with only 20% of your key clients. The point of the Pareto principle is to suggest that you focus your energy on the 20 percent that really matters.

I think this also applies to personal finance. While I am a big advocate of learning as much as you can and doing whatever you can to create wealth, there’s probably about 20% (the vital few) that are truly critical to achieving your financial goals.

So, with this concept in mind, I have outlined what I consider to be the “vital few” or Pareto’s Principle of personal finance.

1) Wake Up! …and commit to taking an active role in creating wealth

For almost everyone, there comes a turning point in your life where you “wake up” and decide you are not satisifed with the financial path you are on and want to make a change. Often times, this happens shortly after college or during a moment of despair about your current financial situation. In order to get on the path to financial freedom, you have to make a firm commitment to doing so…it very seldom happens on accident or by itself.

2) Pay Yourself First

In my view, this is absolutely the single most important thing you can do to get on the path to creating wealth and achieving financial freedom.

– Contribute enough to get your employer’s 401(k) match – right away, as soon as you can…suffer if you must!
– Max out your 401(k) – this will take longer, but is achievable if you are focused
– Contribute and ultimate max out your Roth IRA – you’ll then be leveraging your two biggest tax-advantanged investment vehicles and creating tax-diversification for when you retire

3) Eliminate “Bad” Debt

Mortgage Debt? GOOD. Credit Card Debt? BAD. For most people, credit card debt is the #1 roadblock to achieving wealth. After you “pay yourself first” by contributing the minimum to get your employer match, then go after your “bad” debt. You will not likely get rid of it as quickly as you would like (we are a society of immediate gratification after all), but be persistent and you WILL succeed.

4) Make Smart PURCHASING Decisions (manage your expenses)

You are going to always be buying and paying for “stuff”. Whether it be groceries, a house, a car, daycare, electronics, a wedding…whatever, you are going to be buying it. THINK about what you are buying and ANALYZE whether or not:

– You should really be spending the money. I’m not really talking about things like toilet paper or items you clearly need for everyday living, but mostly the “other” stuff that is usually a “want” versus a need. I’m not suggesting you deprive yourself (you have to find a balance and still “live a life”, but at least THINK.

– If the answer to the above is yes, are you getting the best VALUE? If you’re going to make the purchase, by all means do…but please make sure you are getting the most for your purchase. Most things can usually be categorized as “good” “better” or “best” which usually follows in its price “expensive”, “more expensive”, “most expensive”. EVALUATE all of the options available to you and make the best / most informed choice you can with an eye always toward your ultimate goal of creating wealth / financial freedom.

5) Make smart INVESTING decisions

Doing a good job at saving, eliminating bad debt, and being prudent about your expenses will do you little good if you make poor decisions on how to invest it. There is an almost limitless amount of literature available to educate yourself about what kind of investments make sense for you goals and risk tolerance. The good news is that with just a little knowledge in this area, you will be able to setup your portfolio to meet your needs. In fact, some may suggest you have an even BETTER chance than some “more knowledgeable” because you might not tinker with it as much. There are many stories of how the investor who is constantly adjusting / trying to beat the market actually does worse in the longer term than if he / she had just left things alone.

6) Protect yourself and your family

Make sure you have a will and are adequately insured such as home, auto, health, long-term disability, and life. Nothing can wipe out wealth quicker or devestate your family faster than not being sufficiently insured.

Stimulus Package: Update

So, there they are. Undoubtedly, there are many more good things you can do to accelerate your path to financial well being (don’t limit yourself!). However, if you are able to just focus your time and effort on “vital few”, they should get you most of the way there.