In the last post, I mentioned the Pareto principle or the 80/20 rule. This rule states that for many systems or outcomes, 80% of the consequences or results come from 20% of the causes. I see this rule all the time in my scientific research. Complex systems with many variables often have 2 or 3 important parameters that make a much larger difference than the others. I often spend a lot of time focusing on those 2 or 3 key things to improve the system first before focusing on the more minor considerations.
You can improve your financial situation and your situation generally by applying this principle in your life. For example, in the last post, we talked about how many people need to learn to save more. What is the most effective way to save a lot more? By focusing on getting savings in those areas that cost you the most. Generally the biggest expenses fall into the following categories (roughly in order of importance, although the places shift for different people, depending on wealth level, lifestyle, geography, employment, health, and other circumstances)
1. housing
2. taxes
3. transportation
4. food
5. entertainment (this includes things like travel and dining out)
6. health care
Perversely, in many of these datasets like the one linked above from the US Bureau of Labor Statistics, taxes are not really counted as an expense despite being one of the largest expenses many people will encounter. Some additional info can be found here and here for tax expense data.
Let’s take some example cases from the list and apply the methodology outlined above to improve your savings rate. If your highest expense category is housing, can you refinance a loan at a lower rate? Can you move to a lower cost of living geography and do remote work? Can you live in a more modest house rather than buying all the house you can afford? Can you consider renting instead of owning, or maybe rent out a portion of the property that you own? If you have a high interest loan, would you be able to devote more of your earnings each month to making extra payments to pay down the principle faster?
If taxes are your highest category, can you make better use of tax advantaged accounts (401k, health savings accounts at work, or regular IRA contributions). Instead of frequently trading stocks, can you implement a buy and hold strategy for your stock investing to avoid paying taxes on unrealized gains for many years or decades? (It isn’t an accident by the way that superinvestors implement buy and hold strategies – taxes can be a very large expense and a large drag on portfolio growth if you don’t manage and optimize it.) Similarly, can you change mutual funds from actively traded funds to more passive long term funds which utilize buy and hold strategies? Can you hold less tax favored investments (like REITS or bond funds) inside of a Roth IRA while holding more tax favored investments (like long-term stock holdings) in your regular brokerage account? (You can find more info on this strategy here.)
If transportation is your highest expense, can you consider buying reliable models of used cars that have already depreciated in value substantially instead of buying new every few years? Can you consider paying more for housing near your job to cut back on commute distances and costs for operating your car (while also saving lost time!). Can you consider relying more heavily on public transportation to get you where you need to go?
And so on…you get the idea. By attacking the highest expense category first, you are likely to make changes that have a big impact on your savings rate. If you have made all of the changes that you can, you move to the next highest expense on your list to begin optimizing. You should know which expenses in your life are highest, and if you don’t, your first priority would then be to develop an understanding of where you spend your money.
Let’s take another example from another area of your life. Let’s say, for instance, that your health is not as good as you would like. What are the top causes of poorer health conditions or outcomes, generally speaking? Diet, exercise and sleep are the most common areas in the developed world where you have a measure of control and where the greatest improvement is realized. So, it most likely makes a much smaller impact to try some new unproven fad, rather than focus on eating a healthier diet with less sugar, for example. Obviously, if you have a genetic health condition your situation could be different, but for many people, diet, exercise and sleep will be the top 3 areas that will make the most improvement for quality of life, longevity and overall health.
Using the Pareto Principle to guide you, you can quickly zero in on the important areas of focus. This is why in my investing practices, I like to look at the few things that seem to really work, taking the cue from what successful superinvestors have done. In addition to this, we can apply the Pareto Principle to understand the few most important factors that a company possesses in order to produce extraordinary returns, namely durable and sustainable high returns on capital, pricing power, and a moat protecting their castle of value. Analysis of these two areas with the Pareto Principle in part, led us to create the Star List investing method to earn outstanding returns over time. If you can distill a problem down into the essential elements that make the greatest difference in outcomes, you can use this strategy in your own life to quickly improve your situation too.
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