The Pareto Principal and Its Effect on Your Wallet

The Pareto Effect states that 80 percent of results comes from 20 percent of effort. Here's how you can use it to reliably guide your financial decisions.

The Pareto Effect (or Pareto Principal) was first put forward by statistician Vilfredo Pareto in the 1900s. And while Vilfredo was one weird guy whom none of us would fully agree with (he was openly a fascist, among other things), we must admit this particular discovery is helpful. Not just to economists, but to our own wallets.

What is the Pareto Effect?

The Pareto Effect states that the minority 20 per cent of input can be responsible for 80 per cent of the results. It’s also often called the 80/20 model. The most common example is how, in most societies, 20 per cent of the population controls 80 per cent of the wealth.

(In reality, the equation is not exactly 80/20 – there are situations where one per cent may control 90 per cent of the wealth, for example. But the general idea is that the minority can control most of the available resources.)

In personal finance, the Pareto Effect can be applied in several ways:

• The 20 per cent savings model
• Recognising the minority of financial decisions are major ones
• Realise that 80 per cent of your effort may only yield 20 per cent of the result
• Before buying, remember you probably won’t use it

The 20 per cent Savings Model

This is the most commonly applied form of the Pareto Effect. This rule of thumb states that you can spend 80 per cent of your monthly income (on both needs and wants), so long as you remember to save at least 20 per cent.

While this 20 per cent is set aside and left to accrue compounding interest – such as at four per cent per annum from your CPF, or an endowment fund – you will usually be able to meet retirement goals; even if the bulk of your monthly income is spent.

You will notice that CPF already requires you to contribute 20 per cent of your monthly pay cheque; now you know the reason.

The Minority of Financial Decisions are Major Ones

If we follow the Pareto model, we’ll realise there’s no point poring over every single purchase. The majority of buying decisions, which we encounter every day, have a relatively minor impact. These are things like:

• Whether you should use Grab during the surge, or wait till it’s over
• Whether you should cross two streets to get a plate of chicken rice that’s 50 cents cheaper
• Whether you should get a S$10 haircut, or indulge a little with a S$25 cut

These make up 80 per cent of our regular decisions, and impact 20 per cent of our lives.

It’s a minority input, a handful of infrequent financial decisions, that have a much wider impact. These are decisions such as:

• When you decide to buy a house
• When you decide to get marred
• Whether you spend on getting a degree, or go out and work right after you get your diploma
• Whether you’re going to take on a seven-year car loan

These make up 20 per cent of the decisions, but impact 80 per cent of your life.

This should bring you to a simple conclusion: you should do intense research, and take great care, with the 20 per cent of major decisions.

Don’t waste too much willpower on the small stuff, like haircuts and coffee – if you behave with financial prudence 80 per cent of time, it’s okay to occasionally indulge in an overpriced coffee or restaurant 20 per cent of the time.

80 per cent Effort, 20 per cent Result

Simply put, working harder doesn’t mean earning more. Anyone who has tried to find a side-income will know this rule very well: out of all the things they try to build passive income, only 20 per cent have a real impact.

If you’re struggling to grow your income, and nothing seems to work, bear this in mind. You’ll find that everything you try – from stock investing to selling t-shirts on a blog shop – either don’t work, or aren’t worth the time.

It’s okay, you’re not stupid or messing up. That’s normal for everybody. We need to keep trying until we find the 20 per cent of things we can do, that actually work. In the meantime, most of what we try will fall flat. Shrug it off, and try something new.

On a related note, this also means you shouldn’t over-invest in new attempts. Don’t pour your life savings into your new side-business; always act as if there’s an 80 per cent chance it won’t work.

(If it does work, you’ll be extra pleased. If it doesn’t, at least you won’t be crushed financially and mentally, and can move on fast).

You Probably Won’t Use What You Want to Buy

Most people use 20 per cent of all the stuff they buy. For example, 20 per cent of your wardrobe is probably used 80 per cent of the time.

This applies to almost everything – from apps on your phone, to books, games, cable channels, and gym subscriptions. Most people use far less of what they buy than they would like to believe.

The next time you’re about to purchase something, remind yourself of the 80/20 rule. Chances are, your mind is exaggerating its usefulness to you.

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