The 80/20 Rule of Money Management
What is the 80/20 Money Management Rule?
Some people love to manage their money.
The idea of tallying every transaction on a spreadsheet is their idea of a fun night in.
Others, though, aren’t so keen.
If they wanted to fiddle about with figures on the computer all day long, they would have gone into accounting.
It seems boring and tedious.
When it comes to money management, people fall on a spectrum.
At one extreme, you have the accountant-types: people who like to record every transaction and know precisely how much money they have in their accounts at any given time.
And at the other, you have the apathetic – those who would prefer to get their teeth pulled than create a household budget.
If you’re one of those who jots down every transaction, this post isn’t for you.
You already love budgeting and managing your money, and you’re in an excellent position to secure your financial future.
If, however, you loathe the prospect of monitoring your spending, then you should continue reading.
This article introduces you to a concept that lets you have your cake and eat it too.
You can have excellent money management, minus the effort.
The Magic Of The 80/20 Rule
In life, there are relatively few shortcuts.
If you want something valuable or rare, you usually have to work hard to get it.
There are, however, some exceptions.
Vilfredo Pareto was an Italian economist born in the 19th century.
He observed that there seemed to be a strange phenomenon at work in the economy.
Wherever he looked, he saw that 20 percent of the causes tended to generate 80 percent of the effects.
- 20 percent of the people, for instance, held 80 percent of the wealth;
- 20 percent of workers generated 80 percent of company output;
- 20 percent of time spent on the job accounted for 80 percent of the productivity;
- 20 percent of ideas led to 80 percent of the results;
- 20 percent of countries owned 80 percent of global wealth.
The list of observations went on and on – so much so that Pareto wondered whether he had uncovered some fundamental truth about the universe.
His empirical law seemed to apply to pretty much everything, even stuff that had nothing to do with the economy.
In hindsight, we can see the value of his observation.
The 80/20 rule – often called the Pareto principle – is a byproduct of distributions.
In any population, you necessarily have some elements that exert an outsized effect on outcomes.
The rule, therefore, is an approximation of how distributions play out in reality.
Microsoft, for instance, estimates that 20 percent of bugs are responsible for 80 percent of crashes.
Pareto’s tapping into a fundamental truth about the world provides an important lesson for all of us: you can get big effects from small causes.
In other words, you don’t have to work as hard as you think you do to get results.
So what does any of this have to do with money management?
Well, it turns out that the Pareto principle applies just as much to the economy at large as it does getting control of your finances.
When you understand how it works, you can game the system.
You can put in a small amount of effort to money management and get massive results.
Examples Of The 80/20 Rule In Action
The 80/20 rule of money management is an example of the philosophical notion of being good enough in action.
Having perfect personal finances is unrealistic for most people, just like being an ideal parent or eating a perfect diet.
Furthermore, going to financial extremes can hurt your wellbeing.
Worrying over every cent you spend can make you stressed and miserable.
Pareto never said that people should shoot for perfection.
In fact, his principle leads to a different conclusion: you should keep putting in effort until the results you get slow down.
This idea relates to the concept of diminishing returns.
The more effort you put in, the smaller the reward you get out.
So, in the current example, the first 20 percent of actions you take to manage your money generate 80 percent of the results.
After that, it doesn’t make as much of a difference.
Thus, you can get the results you want without spending hours poring over spreadsheets and tallying your financial statements.
Small changes can have an outsized impact that makes a massive difference.
Here are some examples of the 80/20 rule in action:
- Automating your savings. Who wants to spend time every month, putting money into savings accounts and investment vehicles? If you’re one of those people who hate managing money, not you. The good news, though, is that you can automate savings. Just set up a facility with your bank to withdraw money from your current account and deposit it where you would like. Once in place, you never have to think about it again.
- Automating your bills. The same principle applies to your bills. If you get paid on certain days of the month, set up direct debits that automatically take money from your account. You can do the same for rental payments.
- Setting up a budget app. Why bother recording details of all your financial transactions on a spreadsheet when modern apps can do it for you? Setting up an app is exceptionally easy. Once you’ve done it, you can get it to send reminders if you’re at risk of missing your financial goals. These apps link to your bank accounts, automatically tracking and recording your transactions, so you don’t have to.
- Automating your retirement. These days, you don’t have to spend hours figuring out how much you need to save every month to reach your retirement savings goals. All you need to do is pick a target lump sum and get an app to figure out the details for you. If you want to retire with $750,000 when you are 65, you just tap the details into the app, and then it will estimate how much you need to put aside every month.
- Automating your taxes. Your employer deals with the vast majority of your taxes. If you work for yourself or have a lot of investments, you may have to file yourself. The good news is that now you can automate the process using accounting software. TurboTax and others import tax information and then automatically calculate what you owe, without any of the usual adding up on the calculator.
All of these are great examples of the 80/20 rule in action.
You put in a small amount of effort and get massive benefits in return.
Importantly, you don’t have to be perfect in every way.
You just do the easy stuff with the most significant effects and forget the rest.
Pareto teaches you that it’s not worth your time.
The 80/20 rule applies in other realms, too, such as dieting and investing.
You could spend years of your life researching the optimal combination of foods and fasting to achieve lasting health and longevity.
Or you could just throw out the packaged junk in your house and eat things you have to cook instead.
Similarly, you could dedicate your time to eking out returns in the stock market by analyzing financial statements and mining data.
Or you could just hand over the task to a robo-advisor and get it to do it for you.
Better yet, you could just buy a market ETF and wait for the compound interest to roll in.
Your returns will be average, but so what?
Most retail investors lose money in the stock market when they manage it themselves.
Average is good enough.
How The 80/20 Rule Motivates You
The most important feature of the 80/20 rule, though, is how it changes your psychology.
Making significant life changes is difficult.
We’re creatures of habit.
We don’t like disruption.
The 80/20 rule, however, reminds you that you don’t need to be a perfectionist to improve your situation.
You just put in a little effort, and you can see substantial results.
When it comes to diet, for instance, all you need to do is stop eating candy, ice cream, and cookies, and you’re well on your way to success.
Usually, you don’t need to change anything else to see significant results.
With money management, it is the same story.
You don’t have to be religious about accounting to get on top of your finances.
Just a few tweaks here and there is often all you need.
Budgeting and investing are both hard.
But when you see that you can get 80 percent of the results from 20 percent of the effort, the road ahead of you doesn’t seem so daunting.
If you’re struggling to manage your money, you might want to speak with an accredited credit counsellor.
They can look at your current financial situation and then tell you whether you need to make changes.
Furthermore, they can show you how to make the process of looking after your money easier.
Take control of your finances today.