WHAT is the Pareto Effect? Its the idea that 80% of results come from 20% of the effort. It’s also known as the 80/20 model and doesn’t that sound great?
It was originally coined by an Italian economist named Vilfredo Pareto who was really referring to the fact that 20% of the people owned 80% of the wealth.
But, you can apply this rule to your finances and make it work for you.
Most of us spend everything we earn or we spend more than we earn and end up in debt.
Imagine if you could make 20% of your income to master financial security.
Take your time when making the infrequent 20% financial decisions that will impact 80% of your life.
This includes purchasing a property, the decision to get married or having children, extending your studies with a post-graduate degree, or buying a new car.
All of which would require you to do thorough research and take great care before jumping into these large investments – in life and financially.
The financial decisions you make 80% of the time, like what to eat and where to spend your money only really impact 20% of your life so don’t waste too much decision making on the small stuff.
Now the ratio may differ of course, but it’s the principle that we’re referring to.
Do you use what you buy? A simple test is to look at your wardrobe. Do you wear 80% of your items or 20% of it?
If you fall into the latter, then spending on more clothes would not make much sense.
This concept can apply to everything in your life – apps on your phone, books, gym subscriptions, paid cable channels.
Next time you’re thinking about splurging, consider the 80/20 rule and whether it will be useful or worth the cost.
It works on your investments too. If you are working on growing your wealth through investments, good job!
But with the 80/20 model, it’s not a good idea to invest all of your money into one single vehicle, the odds are that it would not reel in many results.
Don’t pour your life savings into new ventures, as there could be an 80% chance it won’t work out.
Of all the investments you have, chances are, there’s a smaller group of them that actually give you fruitful returns.
In this case, 80% of your efforts give you 20% of your results.
And that’s okay, it’s normal and this is how it is for almost everyone. Keep trying until you can milk that 20% of investments that actually do work.
And the most common uses of the Pareto Effect - save 20% of your income. It allows you to spend 80% of your income as long as you save 20% of it.
This means if you earn RM5,000 a month, set aside RM1,000 to your savings and spend the remaining RM4,000 on both needs and wants.
If 20% is too large an amount to start with, slowly build yourself up towards that and start with 2%, move up to 4% and keep going. The idea is that the smallest of steps will achieve positive results.
Saving 20% of your monthly income may seem like a challenge, but in smaller chunks, it can be achieved.
When your income rises, your savings will too. If you are looking for ways to build your various types of savings for your short- to long-term goals, the 80/20 model will put you on a firm footing.
Nadia Khan is content manager at https://www.comparehero.my/ dedicated to increasing financial literacy and to help you save time and money by comparing all credit cards, personal loans and broadband plans in Malaysia.
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