The Pareto Principle And Savings

By Rachel Brown | June 28, 2012 AAA

According to CNN Money, 28% of Americans have no emergency savings, with more than a quarter having not a penny saved. With unstable job markets and recessionary times, it becomes more important than ever to ensure that you have funds available for the worst. Furthermore, the days of pensions being sufficient to support us in our retirement are over. If we want to live in financial independence, the onus is on us. So, how do we ensure we have sufficient savings for both the short and long term? Perhaps it is time to implement one of the observations from our times to help in this endeavor.

SEE: Protect Your Savings From Their Greatest Threat - You

The Pareto Principle
Originally coined in the early 1900s by Italian economist Vilfredo Pareto, the Pareto Principle is the observation of the 80/20 Rule, which states that in some instances, 20% of the inputs can be responsible for 80% of the results. In Pareto's case it meant 20% of the people owned 80% of the wealth. For us, perhaps it should mean that for financial independence, we should be saving 20% of our earnings and spending just 80%.

How to Save 20%
Worryingly, most people are spending every cent they earn โ€“ with nothing left over. Many are spending much more than they earn and are deeply in debt. When this is the situation, 20% seems a huge proportion, but it is possible to build up to this. If you truly want to save and master financial security, start by saving 2% of your income. This is a manageable amount, and can likely be achieved with little effort. Be sure to set this up in a separate saving accounts where you deposit the funds, this way you will see the rewards of your effort. In no time at all, this fund will grow and you will be comfortable living on 98% of your earnings. Then increase your savings to 4%. Do this month by month and take small steps towards the Pareto Principle goalpost. As you do this, you'll become more and more aware of everything you are spending, which will make your eventual goal of 20% achievable.

SEE: The 7 Best Places To Put Your Savings

Maintaining with a Low Salary
If you are earning $20,000 per year, a high proportion of your income may be tied up with bills. Where could you make cutbacks? If you are committed to beginning a lifestyle of saving rather than spending, you must look at all outgoings and spend with a critical eye. Do you have a car when you could cycle? Do you buy your lunch every day at work, when leftovers would save $5 each day? Could you move providers for your household bills?

If you are struggling, return to the principles we have discussed. Save 2% or 3%. Once you stop noticing the cuts to your lifestyle, make it 5% or 6%. Repeat this process until you the reach 20% that seemed impossible just months before. Remember, creating the saving habit will set you up for life. As Greg McBride, senior financial analyst for Bankrate.com puts it "The biggest barrier to saving is not being in the habit of saving. By establishing that habit, even if an unplanned expense comes up and wipes out what you've accumulated, you're only one paycheck away from restarting the saving process."

Continue When You Make More
Unless you are in your first or second job, the chances are that since you started working you have increased your salary โ€“ possibly substantially over the years. If you do not have savings then these pay increases have not made a difference to your financial situation or financial future. Your outgoings have simply risen in line with your new salary.
This is very common, but in order to become financially stable, you must break this habit. You are already aiming to save 20% of your current salary or earnings. Once you have achieved this, make a resolve that every time you receive a pay raise of any size, you will save 50% of the increase.

Fifty percent of the pay raise is yours to spend โ€“ to improve your lifestyle or put towards the nicer holiday. Half of the increase goes into saving for your financial future. This way you will see your savings rise through the years, and pave the way for financial security.

SEE: Top 4 Reasons To Save For Retirement Now

The Bottom Line
We have seen Pareto's 80/20 rule be proved as accurate in many areas of economics, business and finance, so it seems to make good sense to apply it to our personal finances as well. Saving 20% of your salary from a standing start seems a challenge, but in manageable chunks it can be achieved. As your salary rises, so too will your savings. If you are serious about becoming financially secure, Pareto's Principle will put you on firm footing.

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