The Pareto Principle, named after economist Vilfredo Pareto, specifies that 80% of consequences come from 20% of the causes, asserting an unequal relationship between inputs and outputs. This principle serves as a general reminder that the relationship between inputs and outputs is not balanced. The Pareto Principle is also known as the Pareto Rule or the 80/20 Rule.
How does it apply to Personal Finance? From the psychology of money, it has been seen that people spend an enormous of time and worry on the 80% (investing), when the 20% (money management) is more important. This 20% affects the 80% of consequences in personal finance lives.
So why the focus on 80% and not 20%?
Is it the shiny object syndrome? Is it the love for complexity in our lives? Probably both and much more. The human nature is that inherently we like to think we are smarter than rest of the world. This is ingrained in us since childhood by the school system, parenting and environment which put us into competition with everything and everyone around us. Growth and competition are so overrated that people do not care about fundamentals and basics. See for example, a musician nowadays. Instead of practicing the craft to perfection, the first goal or validation is always performing on stage. Thus simplicity is scoffed at or at best delegated to the fool’s paradise. Personal finance is no different.
When I talk about helping people with managing their money, the first question often I deal with is “Do you advise on investments? Which stocks will I buy?”, “Are you a Financial Advisor who will help me invest?”. It does not matter that most people are not good at managing their money or just scraping by month-to-month, living their lives. They do not see the possibility of managing and planning their money, because it is not too sexy and it does challenge their pride that they need help for such a basic aspect of their lives.
So what is the 20% of Personal Finance?
It is that 20% of their money problems, they do not want to see. They are more concerned about the 80% which will grow their money through risky investments. What is often lost in the hype of investments is that if you can manage your 20% better, your 80% will be even better. When you can save money and manage your expenses, you have more money to plan for in the 80%. I am not saying investments are not required, they are absolutely necessary to beat inflation and for your long term prosperity.
Another way to see the Pareto Principle in Personal Finance is comparing with planting trees in your garden. A gardener spends most of his/her time in preparing the soil and conditions before even planting the seeds. The tree takes off over time from this solid foundation placed on the ground. Even a multi billion dollar enterprise like Amazon puts much emphasis on basics – the two pizza rule to feed a team.
However this should not be confused with stinginess – looking after the pennies to manage the dollars. That is a different matter altogether, when you have to manage tightly to get out of debt or fixing your financial situation.
The 20% of Personal Finance consists of the following 7 principles or skills.
- Knowing your current situation – your financial health check
- Managing your debt and becoming consumer debt free
- Building and living by a Value based spending plan or budget
- Saving for short term and medium term goals
- Having an Emergency Fund or a Sleep Well Fund
- Skills on how to allocate a lump sum of money according to your goals
- Buying a home in the right financial way, that you can truly afford
Once you have figured out your way of mastering the 20%, the rest 80% can follow from a solid base.
- Investing in mutual funds or index funds
- Investing in retirement plans – 401k, IRA, NPS
- Buying investment real estate
- More risky investments – gold, crypto, commodities (yes gold is risky as an investment)
- Investing in your own business
Conclusion
If you live and manage your finances by the Pareto Principle, you will have lots of confidence and a financial plan which is solid. It will help you invest (the other 80%) with a position of strength and long term success. This is akin to a mountain where the majestic peaks we see are standing on a much broader base.
The Log House 