Pareto's Principle Revised …

There is a common thread running through the Personal Finance blogosphere that goes something like this:

80% of people live beyond their means, but the 20% who live within their means & save diligently will be A.OK

Then I come along and run a whole series of posts seemingly debunking various financial ‘truisms’, such as the old ‘save you way to wealth via your 401k’ chestnut and many people no longer know what to think!

Heidi summed up the mixed feelings out there nicely in a comment to one of my many recent 401k posts:

Very interesting. Goes against the grain of all of the personal finance blogs I frequent. I do have to agree with Lee, though, that at the very least [their 401k’s] gets people saving. I know way too many 40 year olds who haven’t even started and are too strapped for cash living their keeping-up-with-the-joneses lifestyle.

To me, this is not an all or nothing situation … you can save via your 401k (if you like) but, at the same time still do other things to set yourself financially free.

I was struggling to find a way to illustrate this when I came across this post in the Simple Dollar; Trent says:

In a visual way, my spending used to look something like this over time (with green representing spending and blue representing income):

graph 1

… and now it looks something like this:

graph 2

Aha!

At least, this represented an ‘aha moment’ to me …

… you see, Heidi is concerned about the 80% of people who follow Trent’s old pattern: they spend what they earn and then some.

We all know what to expect from their financial future: disaster!

So Trent’s blog, and most other personal finance blogs are aimed at the 19% of other people who see the folly in that pattern of living and concentrate on frugality (and, saving the difference) to turn their financial lives around. They try and follow Trent’s second chart.

But, now we have a mathematical problem … our Pareto’s Principle (a.k.a. The 80/20 Rule) only adds up to 99%:

– We have the 80% who are financial deadbeats and don’t bother reading personal finance books or blogs, let alone implement any of the simple methods to keep themselves out of the poorhouse

– The we have the 19% who do read the PF books/blogs and practice at least some of what they preach

What about the ‘missing’ 1%?

They are the ones who realize that as well-meaning as the common financial wisdom is, it can never actually make them all that much better off than their ‘poorer’ cousins … saving alone will not make them rich (or even wealthy)!

So here is how Trent’s chart for the 1% who do want to become truly financially free needs to look:

It’s a simple three step process:

1. Start implementing some sound Making Money 101 techniques to get your ‘green line’ of spending in order (most PF Blogs stop there), then

2. Start implementing some sound Making Money 201 techniques to get your ‘blue line’ of income (job/investments/business) pumping (but, don’t make the mistake of letting your ‘green line’ follow; instead invest the difference between the two lines wisely), then

3. When you retire (early!) and your ‘blue line’ disappears altogether, use sound Making Money 301principles to make sure that you can still safely maintain your desired ‘green line’ spending level … then, relax and drink plenty of pina coladas whilst lying in your hammock.

So, Heidi, we aren’t really saying that the other PF blogs (and their devotees) are wrong … we’re just asking a simple question:

Once you have your saving ‘house’ in order, why stop there? 😉

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6 thoughts on “Pareto's Principle Revised …

  1. AJC, I’d like your opinion on investment newsletters such as those offered by the guys over at Tycoon Research. Is it possible to use this in your money making 201 phase. At the moment I’m still in making money 101 but I can’t shake the idea of leveraging someone else’s knowledge to make you money. Of course, as with all things, you should know enough not to be taken for ride.

    Once again, thanks for an invaluable service

  2. @ Ryan – Great question! I will post on this … in the meantime, nothing wrong with a bit of selective reading, but don’t just blindly follow what you read.

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  4. I say do both! invest via 401K and maximize income streams (beyond your job) and other investments.

    I do both- I have a long term captial bucket and a risk capital bucket

    Long term is for my family needs (retirement, life insurance, college fund, savings)

    Risk capital ( individual stocks and business income)

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