The Pareto principle, commonly known as the 80-20 rule, suggests that 80% of outcomes arise from just 20% of the actions. This rule is witnessed in multiple domains. For instance, in the business sector, 80% of revenue usually comes from 20% of the clients. Income disparity studies indicate that 20% of the population rakes in 80% of the earnings. This principle has empirical evidence backing it across numerous areas.
Delving into personal finance, which factors, when done correctly, contribute significantly to financial growth?
At the outset of this piece, my goal was to outline principal strategies that form the crux of financial guidance. I thought of all the standard advice like steering clear of credit card debt, maximizing your 401(k) company match, ensuring housing expenses don’t exceed 30% of your earnings, saving a minimum of 20%, and so on. This list began to mirror Harold Pollack’s financial guidance card.
However, as I elaborated on these, a central theme emerged.
I was aiming to pinpoint the “Pareto Principles” for personal finance, but instead, I unearthed a Primary Financial Rule.
Primary Financial Rule
I’ve dubbed this the Primary Financial Rule, inspired by a renowned series:
“Resist the urge to spend your future money today; instead, save today’s money for the future.”
Consider money as a representation of your time. Overspending today limits future choices, while saving enhances future opportunities.
This single principle captures the essence of a significant portion of financial wisdom.
The Perils of Credit Card Debt
Debt can strain finances. While some debts, like student loans and mortgages, can be justified due to their long-term benefits, credit card debt stands out as detrimental. It’s costly, often incurred for short-lived pleasures, and typically indicates living beyond one’s means – essentially borrowing from your future self.
Avoiding credit card interest alone places you ahead in the financial game. As of 2023’s first quarter, the Federal Reserve Bank of New York highlighted that Americans owed a staggering $986 billion in credit card debt!
Assuming an average family debt of $6,000 at an 18.9% interest rate, with minimum 4% monthly payments ($240), it would take 33 months and almost $1,700 in interest to clear. Alternatively, investing the monthly interest amount in an 8% annual return index fund for 5 years would accumulate to roughly $3,800.
The essence of the Primary Financial Rule here? Accumulating debt signifies spending future resources. Committing to a high-interest obligation, like credit card debt, is detrimental.
Retirement Savings and Company Benefits
If your job provides a retirement plan, especially with company-matching contributions, embrace it. It’s essentially free money!
On the topic of maximizing your 401(k) and Roth IRA contributions, these avenues offer excellent retirement savings opportunities. Aiming to save as much as possible early on, considering the tax advantages, will set you on a prosperous path. However, a startling report by the National Institute on Retirement highlighted the dismal state of retirement savings: almost 40 million working households lack retirement savings, with the median retirement account balance being a mere $2,500.
The Primary Financial Rule’s relevance? Contributing to retirement funds showcases a commitment to future financial security, albeit with penalties for early withdrawal.
Exceptions to the Rule
Like all principles, there are exceptions.
Certain financial commitments can be prudent, given a valid justification. Take insurance, for instance. While often seen as a necessary expenditure, it offers invaluable protection. In my younger years, I recall friends enduring accidents due to both reckless and routine activities. But as age advances, life’s fragility becomes evident, making insurance crucial to cushion life’s unpredictabilities.
Mortgages are another example. A home purchase entails decades of fixed payments, but it’s a commitment towards a long-term asset. Ensure this commitment doesn’t strain your finances, typically not going beyond 30% of your income.
Commitments like cell phone bills, rent, and similar recurrent expenses should be approached cautiously as they impede financial flexibility. Moreover, some commitments are less tangible yet equally significant, like raising children – a decision requiring thorough contemplation!
In essence, while financial rules are pivotal, the most crucial aspect is understanding and customizing them to one’s unique life journey.
