What is the Pareto Principle?
The Pareto Principle states that for many outcomes roughly 80% of consequences come from 20% of the causes. Another name for this principle is the 80/20 rule. Simply put, 80% of results are due to only 20% of the cause. This was discovered by an Italian economist by the name of Vilfredo De Pareto when gardening discovered that 80% of his pees were produced by 20% of the plants. He also saw this principle in effect when he realized that 80% of the land in Italy was owned by just 20% of the people. a few other examples of this in every day life:
- 20% of a company’s customers are responsible for 80% of the sales.
- 20% of a company’s employees are responsible for 80% of the results.
- In investing, 20% of the holdings in a portfolio are responsible for 80% of the portfolios growth. The other side of this is also true with 20% of a portfolios holdings causing 80% of its losses.
- 80% of social media shares involve 20% of posts.
The examples go on and on, but we are going to focus this rule in our investing and financial planning.
The Pareto Principle helps us focus on what is most important and forget what is not working out in our favor.
What is the “20%” you should focus on that will gain you the “80%” in your journey to wealth? Well to each person this is different, but some suggestions from me as to what “20%” you should focus on that will have the most impact on your future wealth would be the following:
- Always always always contribute up to your employers 401k contribution limit if you have this option. Once you do this, contribute to a Traditional or Roth IRA up to the IRS limit ($6,000 yearly limit and $7,000 if over 50). Then go back to your employer sponsored 401k plan and contribute up to the 2020 IRS limit of $19,500. The last tax advantaged account you can take advantage of is a Health Savings Account, max this out as well ($3,550 per year limit in 2020).
- For the above steps, make sure to pick road market index funds such as VTSAX and throw a little money towards a broad market bond fund such as BND. Set it and forget it. Check back in about 30 years and realize you are a millionaire.
- Lower your expenses. Especially housing and transportation costs. The biggest expense for the average person is housing, making up roughly 33% of their total budget. The second biggest expense in a person life is transportation coming to a total of 16% of their monthly budget. Get a roommate, carpool, bike, anything will help you here.
- Never hold a balance on your credit cards, always pay it off in full. It is an absolute myth that you need to hold a little bit of credit card debt to improve your credit score. Most credit cards have exorbitant fees and APYs which cost you immensely.
- As your wealth grows and income grows as you progress in your career, make sure to reign in lifestyle creep. Don’t spring for the latest sports car or designer clothes just because you can afford it now. Keep your lifestyle the same and treat yourself once in a while.
That’s really it, if you take care of these items which would be considered your “20%”, down the line, 80% of your wealth will be due to these steps you’ve taken as a young adult (or older adult these steps are essential for anyone).
Less is more…
Forget about the other fluff, active trading, actively managed funds, expensive portfolio/financial advisers, side hustles, second jobs, and anything that sounds too good to be true. Stay the course Jack Bogle style and with time you will reap what you sow. The math supports you, the earlier you invest the more the Pareto Principle provides you with wealth. Take a look at this article discussing the math behind how the Pareto Principle affects your investments over time.
This post ties in to our previous post regarding investing and the importance of getting to your first $100,000 invested. Read it here.
Thank you,
– E J
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