A common budgeting mistake is focusing too much attention on time-consuming activities that don’t significantly improve your financial situation.
Following standard advice to clip coupons or cut out small indulgences like a cup of coffee can lead to savings but may not be the massive budgetary improvement you are looking for.
Plus, that cup of coffee might be one of the things that bring you the vast majority of happiness and allows you to function at your peak during the day.
In fact, micromanaging hundreds of little expenses each day can take up hours of time. But, ultimately, it'll only impact your overall financial situation by about 20%.
It's just not a good use of your time. A better solution is to follow the 80/20 rule.
The 80/20 Rule
The 80/20 rule is a rule of thumb also known as the Pareto principle or the law of the vital view
The 80/20 rule says that 80% of your results come from just 20% of your effort.
Conversely, 80% of your efforts only affect 20% of your results.
An Italian economist named Vilfredo Pareto first formulated this basic idea in the 1800s when he observed that 80% of the land in Italy was owned by 20% of the population.
He then started seeing the principle at work elsewhere in his life. He even noticed that 80% of the peas in his garden came from just 20% of the overall pea pods!
There are more examples in your everyday life:
- You wear 20% of your clothes 80% of the time.
- 20% of your business customers are responsible for 80% of your sales.
- 80% of wealth is owned by 20% of people.
Because 80% of your financial consequences stem from 20% of causes, identifying and then focusing on that 20% can be critical in gaining control of your money.
There are many ways we could interpret the 80/20 rule when it comes to money.
But the basic idea is applying the rule to your finances to make your lifestyle more financially responsible.
It lets you find the right balance between looking after your short-term well-being and thinking about your future.
It finds the right balance between spending and saving.
It doesn't mean having to give up all of your comforts and things you enjoy.
But it means strategic sacrifices where the payoff, in the long run, will be worth a lot more than temporary enjoyment.
I think that budgeting and setting some money aside during your working years is crucial for living comfortably later on.
Especially after retirement.
The earlier in life people start saving, the easier it is.
That's thanks to the magic of compound interest, which cause your investments to grow over time.
How Does the 80/20 Rule Help me Create a Budget?
By identifying a few big things to change, you can drastically improve your spending habits
The 80/20 rule will give you a holistic view of your finances.
This means you'll get an understanding of how your finances are interconnected and operate as a whole.
You'll be able to identify the big items you're spending the most money on each month.
Even just significantly cutting one of these major expenses is a huge deal.
It will do more for your finances than all of your penny-pinching and coupon-clipping combined.
Imagine saving hundreds of dollars every month by just changing one specific thing in your life!
That's thousands of extra dollars in savings per year!
If you're the average person, you spend roughly 80% of your money on just 20% of your expenses, name housing, transportation, and/or debt.
Here are a few ways you can reduce these monthly expenses:
Reduce your housing costs
Getting a roommate can help cut your mortgage or rent in half.
If your house is really large and you have tons of extra space, consider whether it would make sense to downsize.
Not only will it be a lot cheaper, but a smaller area is also a lot easier to clean!
Combine your different types of debt to lower or eliminate interest.
If you have a lot of credit card debt with high interest rates, you can often save 10% or more by consolidating.
Growing your savings account is important, but if you're losing a significant portion of your pay to interest each month, that's different.
It probably makes more financial sense to pay off your debt before you start saving.
Ride to work with a coworker who lives nearby to cut your gas, parking, and toll costs in half.
Alternating who drives each week makes it fair for both of you, and everybody saves.
If you're lucky enough to live near four of your co-workers, you can all take turns carpooling.
That means you only need to drive yourself one week out of every month.
And everyone cuts their transportation costs by 75%!
Alternatively, one person can drive all of the time.
Then all the passengers can chip in every week to pay for gas and car maintenance.
20% of the effort spent on deciding how to invest will generate 80% of returns.
Boring index funds, low-fee mutual funds, and blue chips are best.
Unless you're an expert, don't think that you can outsmart the market by making risky investments.
You can spend time every week tracking your investments.
You can look at graphs and charts.
You can watch nightly business reports on TV every night.
Maybe you enjoy all of that and consider it a hobby.
But if not, you could just pay someone a percent or two of your profits to manage it all for you.
How much is your time worth to you?
80% of your total grocery bill comes from just 20% of items.
Focus on these items instead of staples.
This will vary depending on your personal situation.
It might be buying cheaper cuts of meat, or a more inexpensive shampoo.
Buying in bulk can also help, especially for larger families.
Of course, the grocery aisle is one place where you can get some small wins without any extra effort as well.
Chances are that you couldn't tell the difference between different brands of canned tuna or beans.
So feel free to swap out name-brand stuff for store-brand on items where you can't taste a difference anyway.
Savings. Put 20% of your income toward savings goals each month, and then you're free to spend the remaining 80% on everything else.
It helps to imagine your paycheck automatically being 20% less.
By the end of the year, you'll be surprised at how much money you've saved.
More Ways to Save
Enrolling in a regular auto-debit savings account will take thinking out of the equation when it comes to saving your money.
You can set up a specific amount to transfer from your checking to savings on a monthly or bi-monthly basis.
Having all of your bills set up on pre-authorized payment won't save you any money.
But it will save you the time each month that you'd normally need to stop and manually pay all of your bills.
It also prevents accidentally forgetting to pay.
Late payments can cost you money on penalties and fees and can have a bad impact on your credit score, so they are best avoided.
Adjust your mindset
When payday comes, get into the habit of thinking that only 80% of your net pay is for spending.
If you don't think of this money as being available to spend, you're much less likely to miss it.
It might be challenging to adjust at first.
But before long, you'll be saving without even realizing it!
These steps are a bigger sacrifice than just giving up your morning coffee, but the impact on your finances will be huge.
More percentage-based tricks and formulas
The 50/30/20 rule
This is a variation on the 80/20 rule:
50% of your income goes toward necessities like housing and bills.
20% goes toward financial goals like paying off debt and retirement savings.
The remaining 30% goes toward your "wants" like entertainment and dining, buying yourself a new TV, or beer.
The main benefit of this plan is that you don't have to feel guilty spending money on those little indulgences that make up the remaining 30%.
You already know that you've been a responsible adult for the month.
Not only have you already paid all your bills, but already contributed to your savings too.
So go on and splurge a little.
There's one thing to watch out for with the 50/30/20 rule though.
The tricky part of this rule can be distinguishing your needs from wants.
Bread and eggs are needs, but popsicles are wants.
Clothing is a need in its most basic form, but only up to a certain point before it becomes a want.
If you want to make this rule work, you'll need to be honest with yourself.
What seems optional for one person might be something that another absolutely couldn't live without.
You don't necessarily need to switch to a minimalist lifestyle.
But generally, the more you're willing to sacrifice short-term, the more you'll see your savings continue to quickly grow as well.
The 20/4/10 rule
This rule focuses around buying a vehicle.
It states that you should put down a 20% down payment, finance your new car for no more than four years, and spend no more than 10% of your gross income on transportation costs.
Many people drastically overestimate what kind of car they can afford.
This rule will help you stay a bit more grounded, and practical next time you're eyeing that Mercedes.
Don't feel ashamed if all you can afford is an older used car.
Unless you're a car enthusiast, I recommend just focusing on something that can reliably get you from point A to point B.
Think of all the money you'll be saving for better things!
Don't Sweat The Small Stuff
Using the 80/20 rule can help alleviate much of the stress around budgeting
Saving money can be hard if you don't have a plan.
If you don't set money aside each month, it's unlikely you'll see your savings grow by any significant amount.
At the most basic level, the 80/20 rule can be as simple as automatically putting 20% of every paycheck into savings.
It removes a lot of the worry and stress around saving.
Instead of trying to have a bit left over each month that goes into savings, you pay yourself first.
It means you're guaranteed to be saving for your future every time you get paid.
The next step to using the 80/20 principle is to identify those 20% of items that you spend 80% of your income on each month.
The most likely offenders are housing, transportation, and debt.
Once you've identified your biggest money drains, you can then take concrete steps to rectify the situation.
I really hope the tips and tactics I shared with you above can help you come up with some creative solutions to reduce these expenses.
What expense have you cut that made the biggest financial impact?
How did you do it?
Any helpful tips you'd like to share with us?
Let us know in the comments below!