Did you know that, back in 2022, the lack of financial literacy cost 15% of Americans at least ten grand? That’s right! While most can find a way to land a dream job that pays well, it’s not everyone’s cup of tea to effectively manage their money. As a matter of fact, many people have no clue that they may be spending more than they should without saving enough for their future!
However, the good thing is that it is never too late to start saving without complicating your finances. All you need is basic knowledge about how to save with regular effective budgeting. That’s why, in this article, we’ll discuss the 80/20 rule to help you simplify your finances while saving for the future!
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What is the 80/20 rule?
The rule of 80/20 states that the inputs or causes are accountable for 80% of the outputs or effects. The rule is applicable in various fields, including business, productivity, economics, and finances. Vilfredo Pareto is credited with being the first to notice the 80/20 rule, commonly known as the Pareto principle.
Vilfredo Pareto, a 19th-century economist and sociologist from Italy, discovered that nearly 20% of the pods of peas in his garden produced 80% of the peas. He took the concept into cognizance and went further to notice that 20% of the population owns almost 80% of the entire land in his country! It established the applicability of the principle in macroeconomics.
It made him contemplate that this same scenario could be observed almost in any field that involved numbers. So, he came up with the principle that 20% of the variables are responsible for 80% of the outcome. The principle is now popularly known as the “80/20” rule.
Although the rule applies in various areas, we’ll discuss its applicability in personal finance.
In the context of savings
When it comes to savings, the 80/20 rule says that an individual should put 20% of their monthly income into savings. However, it’s totally up to you to put your money into a savings, brokerage, or retirement account. The rule focuses on putting aside enough money for the event of financial difficulty. As per the rule, you can use the remaining 80% of your earnings for wants and needs.
Experts also say you should have enough savings to cover your living expenses for at least three to six months. Some even suggest that first building up an emergency fund is wiser than moving on to long-term investments.
In the context of investments
The 80/20 rule may be used in your investment/financial portfolio in two ways. The first way suggests investing 20% of the S&P 500 stocks, contributing 80% of the market’s total return.
The second way suggests creating an 80-20 allocation. That is, putting 80% of your entire investment into low-risk index funds to ensure a lower but steadier rate of return. At the same time, you can invest 20% of your investment into growth funds with higher risk but better returns.
How to draft out a budget using the 80/20 rule
The 80/20 rule is great for someone who does not know much about budgeting. Here’s how you can map out your monthly budget per the 80/20 rule and efficiently save money for your future without worrying about leading your usual lifestyle.
Laying out a Budget
It’s important to create a well-designed layout for your budget. There are several ways for this. You can choose to use an Excel sheet or a notebook to list your income and expenses. You can also find built-in budget templates on Google Sheets that simplify the process and make it more convenient.
Add Your Income
Once you have finalized a layout for your budget, you can go ahead to add your income. You can start by making a comprehensive list of all your monthly incomes. It may include your salary, investment returns, and other sources of income.
Next, make a list of all the planned expenses for the month. It may include rent or mortgage, utility bills, groceries, transportation, entertainment, etc.
Once you have a clear overview, set aside 20% of your total income for savings, this percentage ensures you prioritize building an emergency fund and securing your financial future. Assign the remaining 80% of your income for your planned expenses.
Make Your Budget Calendar
A budget calendar is an effective tool for tracking your financial obligations and commitments. Create a calendar format to mark important due dates for bills and EMIs. By noting down these dates, you will be more likely to pay them on time, avoiding late payment penalties and unnecessary stress.
Your budget calendar helps you stay organized, ensuring you know your financial responsibilities throughout the month. However, only one in three Americans prefers to rely on a planned household budget.
Review the Budget
Regularly reviewing your budget is crucial for its accuracy and effectiveness. Take time to evaluate your budget periodically and make adjustments as necessary. For example, consider allocating the extra money toward your savings if you recently paid off a debt.
Additionally, with changes in your income, you may need to increase or decrease your expenses under different categories. This flexibility allows you to customize your budget to meet your evolving financial goals.
The benefits of using this rule in your personal finance
The 80/20 rule is an easy-to-understand rule that lets even beginners create a budget for themselves. Here’s what makes the 80/20 rule comprehensive, easy, and beneficial.
The best thing about the 80/20 rule is that it is a comprehensive guideline that is easy to follow. It provides a straightforward approach to managing your finances effectively. With this rule, you can simplify financial decision-making by allocating a fixed percentage of your income to savings, allowing you to focus on budgeting the remaining amount.
Designating 80% of your remaining income for expenses is simple and does not require complicated calculations or tracking. You do not need advanced tools or specialized knowledge to implement the 80/20 rule effectively. The rule also allows you to adjust your expenses according to your financial situation, making it adaptable to different income levels.
You Pay Yourself First
The 80/20 savings rule emphasizes the concept of paying yourself first. You prioritize your financial future by allocating 20% of your income to savings. When you pay yourself first, you set aside money for your future self, ensuring financial security and stability.
It is pertinent to mention that according to a 2022 report, you need to earn at least $122000 a year to feel financially healthy, which is still a dream for many! Nonetheless, following the 80/20 rule can help you develop a disciplined saving habit, as you consistently set aside a portion of your monthly income for savings. Therefore, you can still have a financially secure future even if you are not earning as much as $122000 a year.
Helps You Automate Your Savings
One of the significant advantages of the 80/20 rule is that it promotes automated savings. You establish a regular saving routine by allocating a fixed portion of your income to savings.
You can opt for direct deposit or automatic transfers to your savings account, ensuring that the allocated amount is saved without requiring manual intervention. Automating your savings through the 80/20 rule saves you time and effort and eliminates the risk of forgetting to save, leading to a consistent and reliable savings plan.
It Promotes Savings
The primary focus of the 80/20 rule is to encourage savings. By committing to saving 20% of your income, you develop a proactive mindset towards financial security and future goals.
Honoring the 80/20 rule instills financial discipline, allowing you to build a robust savings buffer for emergencies or long-term goals. By consistently following the 80/20 rule, you are more likely to meet your financial objectives, whether saving for a down payment on a house, retirement, or a dream vacation.
The 80/20 rule can further be bifurcated into the 50/30/20 rule.
The 80/20 rule says you should save 20% of your monthly income while using 80% for your expenses. Interestingly, the rule can further be bifurcated into the 50/30/20 rule. Here’s what the 50/30/20 rule implies.
Set aside 50% of your money for your needs
The 50/30/20 rule says that one must allocate 50% of his earnings towards the things that are essential expenses like rent, food, rent, mortgage, insurance, debt, and car payments. These expenses are necessary to carry on with your lifestyle and living.
Assign 30% of your income to your wants
According to the 50/30/20 rule, you can spend 30% of your income on your desired wants. These are the expenses that are non-essential and can be avoided. For example, the expenses for traveling, dining out, purchasing a subscription, etc., all fall into this category.
Save 20% of your income
Just like the 80/20 rule, the 50/30/20 rule also suggests depositing 20% of your income into your savings account to withstand any emergency.
However, people tend to prefer the 80/20 rule as most find it difficult to differentiate a need from a want. Moreover, if you are new to budgeting, the 80/20 rule will help you learn savings without complicating things. But if you want to effectively manage your savings, expenses, and debts, the 50/30/20 rule can be more beneficial.
Saving money for your future while effectively managing your finances can be tricky. However, the good thing is that you can simplify the budgeting process by effortlessly adapting the 80/20 rules. The salient features of the 80/20 rule empower individuals to secure their future while allowing them to look after their present expenses as well.
So, to effectively manage your expenses and save for your future, all you have to do is follow the 80/20 rule!
Who can benefit from the 80/20 rule?
Anyone can follow the 80/20 rule to ensure guaranteed savings. However, the 80/20 rule is specifically meant for you if you do not have great personal finance skills but still want to save money by creating a budget. Even a novice can begin to save for the future using the 80/20 rule.
Can the 80/20 rule help you build wealth in the long term?
When discussing savings, the 80/20 rule tells you to save 20% of your monthly income. While it can get you started with savings, it may not be enough to create wealth in the long term.
However, an alternative use of the 80/20 rule might help you grow money in the long run. All you have to do is invest 20% of your investment in a high-performing growth fund that can offer as much as 80% return. You can invest the rest of the 80% of your investment in low-risk indent funds to ensure the security of your investment.
Is 80/20 a “one size fits all” rule?
While the 80/20 rule allows most individuals to effectively manage their monthly income and expenses while setting 20% of their income towards saving, it is not a “one size fits all” rule. Individuals with higher incomes may not set aside 20% of their income and still manage to save enough. While on the other hand, someone who does not earn a lot cannot save enough despite setting aside 20% of their monthly income.
What is the 50/15/5 rule?
The 50/15/5 rule in personal finance is a helpful concept for managing your money smartly. It says you should use 50% of your income after taxes for important things like housing, utilities, and cars. Save 15% for the future, like retirement or emergencies. Keep 5% for fun things you want, such as trips or hobbies. This rule helps you balance spending, saving, and enjoying the rewards of your hard work.
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