The Pareto Principle is an often misunderstood statistical observation which can have all sorts of applications, including in personal financial planning. Below are some suggestions on how to apply the principle – also known as the Law of the Vital Few – in financial planning.
To boil the Pareto Principle, or Pareto Efficiency, down to its most basic level, the idea is that 80 percent of effects come from just 20 percent of causes. In 1906 Vilfredo Pareto observed that 80% of Italy’s land was owned by just 20% of the population, and that 20% of the pea pods in his garden contained 80% of his pea crop. Business management consultant Joseph Juran developed the idea when he observed that 80% of a company’s complaints tend to come from just 20% of clients, and that in any organisation 20% of employees tend to account for 80% of absences.
Today the Pareto Principle is accepted as fact in many aspects of statistics, business and finance, often without actually checking whether it holds. It is a constant truism in any commercial environment that 20% of a clients bring in 80% of the revenue, and this leads to all sorts of nonsense in workplaces as sales people are forced to identify their key clients and so on. However, the pattern occurs widely in all walks of life – if you take the world’s ten richest people, the top three (at the time of writing, Warren Buffet, Carlos Slim Helu and Bill Gates) have a combined wealth which far outweighs that of the remaining seven.
The Pareto Principle can not be applied to everything, and is often misconstrued (most notably in sales when managers insist on identifying key clients even in high volume markets where the top 20% of customers may easily be outweighed by the purchasing power of the remaining 80%), but it’s a useful tool to apply to financial planning.
The applications for personal financial planning are straightforward. By working out the major areas of a person’s monthly expenditure (rent or mortgage payments are generally first, followed by taxation, food costs, transport, insurance of various kinds and utility bills), the Pareto Principle will tend to suggest that the largest areas of expenditure will account for 80% of a person’s monthly income. By setting up a spreadsheet of monthly expenditure arranged by category, an individual can see where the bulk of their money is going.
When planning finances and monthly budgets, a quick glance at a spreadsheet arranged in categories will reveal the biggest opportunities for significant savings. For most people, accommodation costs are going to be the biggest monthly expense, and these are largely unavoidable except for people who are fortunate enough to be coming to the end of a mortgage or who can relocate to a much cheaper area. Food, taxation and transport are likely to be the next three in most cases, however, and individuals can take steps to lower their expenses in these areas – buying cheaper branded food in the supermarket, for example, hiring an accountant to become more tax efficient, or buying a bicycle to cut down on transport costs.
Applying the Pareto Principle is a great way of encouraging people to prioritise when they plan budgets. Yes, it’s easy to shop around and knock $20 from your monthly cell phone bill, but what’s the point when you can save $100 a month by simply changing supermarket, or by taking public transport rather than driving everywhere?
Applying the Pareto Principle gives many individuals an overall picture of their various financial commitments and provides an impetus to organise their financial planning, to cut their costs in areas where a saving can have the biggest impact. Saving 10% of the pets’ food bill might seem like a small daily victory, but when 40% or more of a person’s income is going straight to a bank in the form of mortgage payments, it might be more constructive to shop around for a better interest rate, for example.
People have so many financial obligations that they can often not see the wood for the trees. Applying the Pareto Principle to financial planning is a simple case of highlighting categories of expenditure and their proportions relative to a given person’s total expenditure. It is a great method for pointing the way to economising measures which can make a big difference to a struggling household.