What’s the 80/20 Rule in Finance?
The 80/20 rule is a popular rule among productivity gurus. This rule is also known as the Pareto principle, named after economist Vilfredo Pareto. The rule states that 80% of your results come from 20% of your work. If you apply that knowledge to your work performance, for example, you may be able to cut back on excessive work and increase your results. Keep reading to learn more about the 80/20 rule and how you can use it in your personal finances.
What Is the 80/20 Rule?
The 80/20 rule is a principle that says 80% of outputs come from 20% of inputs. For example, consider a typical workday for a white-collar employee. Usually, 80% of productivity and results come from just 20% of efforts. And the remaining 80% of work time yields just 20% of the result.
For entrepreneurs and business owners, the 80/20 rule can be incredibly effective. I even applied the this rule in my own business. I noticed about 80% of my time was spent on a service that generated just 20% of my income. So I cut that service and focused all efforts on the part that was taking 20% of my time and generating nearly 80% of my revenue. No surprise, my income grew quickly after making the change.
What if you were able to use this rule in your own personal finances and investment strategy to grow your long-term wealth? You can! Here's a look at a couple of potential uses for the 80/20 rule in your finances.
The 80/20 Rule in Budgeting
For budgeting, the 80/20 rule simplifies your spending plan into one big bucket for spending and another for savings and investments. Having just two budgeting categories to track makes it so easy that just about anyone can do it. And you don't even need a budgeting app to do it for you.
For example, if you make $50,000 per year and follow an 80/20 budget, you would allocate $10,000 per year to savings and investments and $40,000 to all of your other expenses. Many experts recommend saving at least 15% of your income every year for retirement. So 20% is even better.
If you use a more detailed budget, compare the amount you spend to the amount you invest to determine how close you are to the 80/20 guideline. While it's always a good idea to save as much as you can, this budgeting rule is based on sound advice. Need some help with budgeting? We recommended managing your finance with Empower for free.
Learn more: The best budgeting strategies for your unique needs
The 80/20 Rule and Investing
For investing, the 80/20 rule says that roughly 20% of your holdings will yield 80% of your returns. Does that mean you can just invest in one-fifth of the number of stocks as long as you pick well? Not really. It's important to maintain a diverse portfolio. You never know which is the 20% that will return the best results.
If we all knew what we know today about stocks like Amazon, Apple, Microsoft, and Berkshire Hathaway and were able to start investing at the right time, we probably could use the 80/20 rule to make more with fewer dollars. But since we can't predict the future, your best investment plan is likely one that relies on a diverse portfolio that spreads out your risk.
But you can come up with other ways to use the 80/20 rule in your investments. For example:
- 80% of investment dollars in retirement accounts and 20% in a taxable portfolio
- 80% of investments in passive index funds and 20% in single stocks
- 80% of your taxable portfolio in blue-chip stocks and 20% in small to midcap stocks
- 80% of your alternative investments in real estate and 20% in cryptocurrency
There's no limit to the number of ways you can use the 80/20 rule in finance. With the right approach (or the right financial advisor), you could find the 80/20 rule helps you beat the market and get above-average investment results.
Remember the 80/20 Rule in Your Finances and Beyond
Applying the 80/20 rule in my business and finances has led to more money for me and my family. There's no reason you can't use it to optimize your budget, portfolio, career, and other parts of your life. But just don't try to 80/20 your relationship with your spouse or you may end up sleeping on the couch.
For your money, however, this rule is a great tool. Examine all of your finances with an 80/20 lens. You may find places to optimize and improve your long-term results.