Guest writer Keith Whelan on how you can use the 80/20 rule to take charge of your personal finances and increase your wealth.
I’m a big fan of the “80/20 rule,” also known as Pareto’s Principle. It states that 80% of an outcome is usually determined by 20% of the inputs.
For instance, Pareto’s Principle holds true for the following:
- 82.7% of the world Gross Domestic Product (GDP) comes from the richest 20% of the population (1)
- 80% of U.S. health care services are used by 20% of patients (2)
- 80% of U.S. crimes are committed by 20% of criminals (3)
- In general, 80% of a company’s profits come from about 20% of its customers
Although the principle doesn’t always work out to exactly 80% and 20%, it’s a good rule of thumb.
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I like Pareto’s Principle because it can help us manage our personal finances more effectively. For instance, 80% of your wealth usually comes from about 20% of your assets. That means that a few high-impact assets and liabilities can give you the greatest returns.
For the average U.S. household, real estate and retirement accounts make up 80.7% of wealth or net worth (4). Therefore, it’s a good idea to focus on these assets to build wealth. For example, consider how you could build equity in your home faster or maximize contributions to a 401(k) or Roth IRA.
The 80/20 rule can also be applied to liabilities, or debts. Consider which ones are charging you the highest interest rates. You might find that 80% of the interest you’re paying comes from 20% of your debt.
So, find the debt that costs you the most and make a goal to pay it off as quickly as possible. After it’s gone, you’ll have more cash available each month to pay off the next one.
Using the 80/20 rule is a smart way to identify and optimize your assets and liabilities that have the most potential to help you improve your personal finances and build wealth.
(1) The World Bank.
(2) Myrl Weinberg: In Health Care Reform, the 20-80 Solution, The Providence Journal
(3) Career Criminals: Who Are They and What Should Society Do About Them?
(4) Data modeled from Federal Reserve Board 2007 Survey of Consumer Finances and U.S. Bureau of Labor Statistics 2010 Consumer Expenditure Survey.
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Keith Whelan is the founder of CashFlowNavigator.com, a free website offering advice and tools to help maximize your cash flow. It won the prestigious Excellence in Financial Literacy Education (EIFLE) Award for 2012.
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