The Pareto Principle: Reevaluate Your Money

I came across this principle today and found it intriguing because I have known it to apply to so many other things, and yet I have never applied it to personal finance.  My personal experiences with the principle stem from quality control and computer science, but ironically, the principle has its origins in economics. 

A LITTLE BACKGROUND.  The Pareto Principle is more commonly known as the 80-20 rule.  Economists call it the Principle of Factor Sparsity which just furthers my claim that economics is “the science of common sense in a language only few can understand”.  Vilfredo Pareto lived in the late 1800s and helped develop the field of microeconomics, notably the concept of Pareto Efficiency (unrelated to the principle).  He once noted that 20% of Italy’s population controls 80% of Italy’s wealth.  This is why the 80-20 rule is named after him.

QUALITY MANAGEMENT PIONEER Dr. Joseph Juran found what he termed the “vital few and trivial many” which determines where and how companies should focus to increase the quality of their products.  Dr. Juran worked with Japanese businesses after World War II to improve what the world saw as cheap and poor products.  Perhaps due to the processes derived from his work, thought to be an application of Pareto’s observations about economics, Japanese companies have built a reputation for quality and developed processes and business models followed by thousands of companies today.

THAT’S GREAT, BUT HOW DOES IT HELP ME?  Have you noticed that you see this principle nearly every day?  Take a step back and look at your life.  Do you find any of the following apply:
* You spend 80% of your time with 20% of your acquaintances
* 20% of your activities in life account for 80% of your memories
* 20% of your customers account for 80% of your sales
* 80% of complains stem from 20% of products or idiosyncrasies
* 80% of your visitors only look at 20% of your website
* 80% of your money is spent on 20% of the things you own
* 20% of the articles you read in journals/magazines are valuable to you
* You wear your favorite 20% of clothes 80% of the time

What you need to be doing is making sure you’re spending the majority of your time and money doing the 20% of any equation.  Here are a few things that suggest you’re in the 80% group:
* You’re frequently working on tasks you have zero interest in
* It seems like you’re always working on “urgent” tasks
* You’re spending a lot of time on things you’re not “good” at doing
* Activities seem to always take longer than you expect.

People have their strengths and weaknesses, and just like the rule would suggest, we’re probably good and practiced at 20% of all the things we could be doing.  You will find that if you focus on that 20% you will:
* Enjoy what you are doing
* Be good at what you are doing
* Find you are fast at what you are doing
* Be efficient at what you are doing
* SMILE MORE!

OKAY, THERE ARE OBVIOUS BENEFITS TO THIS THINKING BUT WHAT ABOUT FINANCE?  We tend to be consumers – massive ones at that – and we tend to collect tons of meaningless junk.  Sure, we can think of tons of reasons for consuming and keeping, but it really shows in our pocket books.  You probably only NEED 20% of all the things you buy.  The other 80% is unnecessary fluff.  (Hey – I sound like an English teacher).  Concentrate on those 20% things and then ask yourself the following questions to figure out whether or not to buy it…
* How much happier will I be with this thing?
* How often will I use this thing?
* How expensive is this thing?
* How fast will this thing be obsolete?
* How much can I get for this thing when I get rid of it?
* What kind of memories will I have of this?
* Did you research this thing?

Be totally honest with yourself and avoid tricking yourself.  Put it up to the 80-20 rule!

CASE STUDY.  This can obviously be a great tool or it could be a worthless piece of junk.  It really depends on what you’re going to do with it.

How much happier will you be with it?  Don’t just ask will you be happy with it at first or happy with it until something else comes out or happy with it because it’s cool.  Will you be happy with it 80% of the time you use it?  Is it in the 20% of your stuff you’re happiest with?  I’m happy now… will I be 20% MORE happy once I have it?  When you ask these questions do you start to see how FEW products out there will meet these requirements?

How often will I use this thing?  80% of the time?  Are you always going to be reaching for it, or is it going to spend 80% of it’s time on the shelf or in your pocket?  Is it going to be among the top 20% of your objects that get the most use?

How expensive is this thing?  Is it going to be one of the objects that fits the rule “20% of your things that take 80% of your money”?  Those things are NECESSITIES!  Housing (rent, utilities, insurance), Health (food, medicine, insurance), and Transportation (car, mass transit) usually fit those rules.  Things that luxuries or fluff usually end up in this category but are not necessary for your life.  You can cut out those luxuries you truly do not NEED and do not SUPER SUPER SUPER want or you will DIE.

How fast will this thing be obsolete?  In one year will this still be one of your top 20% objects?  2 years?  3 years?  This question depends on the object.  Cars should last 7 to 15 years.  Appliances 12 to 25 years.  Think of what you feel the object should last.  Is there an 80% chance it will last 20% longer than you think?

How much can you get for this thing when you get rid of it?  Will it retain 80% of its value?  Is it going to be among the top 20% of used things people buy?

What kind of memories will you have from this?  Think of travel for example for this question.  Will it be among your 20% most memorable things to have done in your life?  Will you spend 80% of your time actually traveling or will you be in your hotel room doing nothing?  Conversely are you going to spend 80% of your time RELAXING and having FUN (if that’s more your thing) rather than worrying about life and the nagging (yet honestly important) questions?

How much time did your research this thing?  AVOID IMPULSE BUYING!  IT’S THE SINGLE MOST WASTEFUL PRACTICE WE HAVE.  If you can 80% eliminate this practice from you life, I bet you save 20% from being spent on worthless crap.

WHAT I HAVE TAKEN FROM THE 80-20 RULE.  I am lucky I got a job I mostly enjoy doing.  I probably get paid well below what I could have received from other jobs, but I am mostly happy here.  I spend most of my time actually getting stuff done, and very little of my time running around doing the preparation trying to get things done.  I complain about work, but really nothing major.  Like everyone else I can always find something to complain about even if things were nearly Utopian.  At home I have far, far too much crap and I really need to prune.  I spend too much money on junk that I do not keep using.  I buy things that have little personal or retail value.  I hardly (until recently) used a $500 Dell Axim but I’d really hate being without my $15 Patton Industrial Fan.  There’s so much CRAP in my apartment.  I will be going through those things and applying all the 80-20 questions and relationships to those things and will decide what to do with everything from there.  (If you want some free stuff – I’m getting rid of a ton soon!)

Take the time out in the next 2 or 3 days to really think about the 80% of your life that could be made better.  Keep the 20% that’s great.  Throw out 80% of the junk you don’t need.