Wednesday, November 01, 2006

The 80/20 rule of personal finance

"Watch the pennies and the pounds take care of themselves," the old adage goes.

It's a theory a lot of pfbloggers hold near and dear to their hearts. And truth be told, it's not a bad axiom to live by, but a few posts out there in the blogosphere have me rethinking this sort of conventional wisdom.

Does the small stuff really add up?

I found Canadian Capitalist's candid piece on the $8,000 he spent to have an unused van parked on his driveway for a year quite compelling.

I'm paraphrasing him a little bit (and my apologizes if I'm in any way taking his views out of context or misquoting him) but essentially, CC stretches his dollars further by doing things like coupon clipping and brown-bagging lunches to work. Yet on major purchases like homes and cars, though he tries to have a similar nose for bargains, a lot of the time there's wasted money because the item either wasn't really needed in the first place, or wasn't acquired at quite the same bargain level as that 99 cent loaf of bread from the bakery on the other side of town. I think the point is, overpaying for a house or a car you arguably don't need dings your wallet a lot more than those nickel-off-toothpaste coupons can ever hope to offset.

The tone jibes very well with this older Uncommon Way to Wealth post in which the author realizes that while it's nice to mind the little stuff, the decisions that make your net worth grow by leaps and bounds are always the bigger, albeit less frequent, ones.

The inspiration for the piece is the so-called Pareto Principle -- a theory, incorrectly attributed to early 19th Century Italian mathematician Vilfredi Pareto which states that in any given experiment, 80% of the results can be attributed to 20% of the variables.

Pareto originally used the theory to explain how 20% of his country's citizens were responsible for 80% of the income earned in his country. But over the years, it's been used, abused and watered down to the point where other disciplines borrow the same 80/20 ratio for themselves.

For our purposes, I think my own Pareto Principle of personal finance goes something like this: 20% of the decisions we make involving money are responsible for 80% of of how much money we have.

I don't write this to discourage people from doing little things like cutting out expensive lattes, choosing no name products over brand names, and cutting coupons from the newspaper. Those are all great things that can add up.

I just wish people were as exhaustive about the major decisions. Do you really need that new car? Are you sure you couldn't save money by calling a mortgage broker? Maybe they could turn that 5.2% variable rate into a 5.1% variable rate.

At the end of the day, it all adds up. It's just that with the big things, it all adds up a lot faster.


Lazy Man and Money said...

As long as you are going with penny and pound expressions, I'd say this is best described as a warning for people to not be "penny-wise, pound-foolish."

GIV said...

I would have -- but for the fact that CC already used that exact phrase for his post title.

Besides, my version is the one my mom told me when I was growing up.

FIRE Finance said...

This is a great piece of advice for all. It is true in all aspects of our lives, whether it is our time or money.