Use the 80/20 Rule to Maximize Your Financial Opportunities
A number of years ago, when I was working for a big company, we had a team of people working on a project with a fairly simple goal: to keep our customers longer. I knew someone on the team and I remember asking repeatedly — for over two years — how things were progressing. The typical reply was, "Oh, this is very complicated. We're trying to classify every customer and predict when they are likely to leave us. Once we do that we will have to find out why they are likely to leave us. And then…." That's when I usually changed the subject. (See also: How to Have a Better Day at Work)
Needless to say, the project was never completed. All that time and effort wasted. I suggested to the colleague, "Why don't you just '80/20' it?" That is, first focus the effort on just the relatively small number of customers who generate the vast majority of profits for the company and deal with the remaining, less-profitable customers later. In fact, for most companies 80% of profits do come from only around 20% of its customers.
The 80/20 Rule in Nature
But the "80/20 Rule" (also known as the "Pareto principle") doesn't just apply to customers and profits. The rule, which states that 80% of an outcome is usually determined by only 20% of the inputs, holds true for a surprising number and variety of things:
- 82.7% of the world's GDP comes from the richest 20% of the population.
- About 80% of traffic accidents are caused by 20% of motorists.
- Most people wear 20% of their clothes 80% of the time.
It doesn't always work out to exactly 80% and 20%, but the principle is usually a good rule of thumb. In fact, the 80/20 Rule can be applied to the "rule of thumb" — your thumbs account for 20% of your fingers but do 80% of the work!
I like the 80/20 Rule because it can help us manage things more effectively. Things like our finances. (See also: Manage Your Money in 5 Minutes a Day)
The 80/20 Rule and Your Money
Focusing on just a few high-impact assets and liabilities, and the cash flow associated with them, can pay handsome dividends. On the other hand, if you spend all or most of your time trying to micromanage hundreds of smaller daily expenditures, all that effort is only impacting about 20% of your overall financial situation. That's not a very effective use of your time.
80% of your household wealth usually comes from only about 20% of your assets.
What are some of those high-impact items? For the average U.S. household, two assets — real estate and retirement accounts — make up 80.7% of household net worth. So these should certainly be areas to focus on for your wealth creation. (See also: How to Build Wealth With an IRA)
Let's look at how you can increase the value of real estate property and your retirement accounts. Keep in mind that you can grow them in two ways: by increasing your investment amount or by reducing costs associated with them. We'll start with real estate.
Ways to Grow Your Real Estate Equity
The easiest way to grow equity in your home is to purchase a home you can afford and maintain. But if you're already in a home, you have several strategies to boost equity.
Prepay the Mortgage
This is your "biggest bang for the buck" option. You can accomplish it by either refinancing to a shorter term mortgage or by keeping your existing loan and making additional principal payments whenever you can. Refinancing a $200,000 mortgage from a 30-year to a 15-year term can not only save you about $100,000 in interest payments, but it also enables you to pay off the loan years sooner. Owning the asset (your home) sooner increases your net worth, which then frees up substantial cash flow…no more mortgage payments! (See also: How to Refinance Your Mortgage)
Appeal Your Tax Assessment
Since 2007 most U.S. home values have dropped considerably, but in some cases appraised values used to determine tax rates haven't been properly adjusted or they might have other inaccuracies. Filing an appeal requires doing some homework, but it might be worth the effort if it saves you $100 or more per month.
Lower Your Homeowner's Insurance
It never hurts to review not just the amount you're paying for homeowner's insurance but also what is covered. The last thing you need is for your house to be seriously damaged and then learn your insurance won't cover it. In addition to getting "a-la-carte" quotes be sure to also ask your carrier and competitors about their multiple policy discounts.
If you've purchased a house that's bigger than you need with a mortgage that's much more costly than you can afford, you will experience a condition known as being "house poor." When the cost of a mortgage + taxes + insurance + maintenance + repairs for this one asset exhausts all or almost all of your cash, it prevents you from taking advantage of other opportunities to move ahead financially, so downsizing to a smaller home might be your best solution. (See also: What to Do if You’re House Poor)
Move Into an Income-Producer
If owning and managing a multi-family property suits you, it offers a chance to significantly improve your cash flow position — and to grow your equity faster, because tenants are helping you pay off the mortgage. You might even be able to collect monthly income from a one-family home if your primary residence has separate living space that can be rented. You can rent garages, too.
Ways to Grow Your Retirement Accounts
Again, the strategy here is to maximize your investment both in terms of dollars and investment choices, and to cut associated costs wherever possible.
Maximize Matching Contributions
There's no better source of savings than free money! That's what you're getting if your employer has a 401(k), employee stock, or savings account matching program. So be sure to contribute enough to receive the employer's maximum match amount. It might not put money in your pocket right now, but winning at the wealth and cash flow game isn't about immediate gratification.
Invest in Stocks
As Jean Chatzky summarized from a survey for her book The Difference, the wealthy buy stocks. Says Chatzky: "[F]or the wealthy, sound investing was the number one factor in helping them reach their financial status." Why? Because over time stock market growth outpaces inflation. (See also: How to Get Started in the Stock Market With Index Funds)
Include Dividend-Paying Stocks in Your Portfolio
Some stocks have the advantage of potentially growing in value (stock price) over time plus generating "interest" income in the form of dividends. At a time when CD and savings account interest rates are under 1%, stocks with dividend payments of 2% or 3% might be something for you to consider in your retirement portfolio. Like cash flow from company match accounts it's often best to save stock dividends for later use. In fact, reinvesting the dividends back into stock can compound the growth.
Keep Your Management Fees Low
Fees you pay that are associated with the management of your investments can, over time, add up to many thousands of dollars and slow your progress on the path to financial independence. These costs include retirement and mutual fund management fees, trading fees, financial advisor fees, and of course taxes. So it pays to manage them wisely. A good place to learn more about this topic is in Ric Edelman's brief, easy to read book Rescue Your Money.
(Of course, be sure to consult your financial advisor about stock allocation strategies most appropriate for your situation.)
Numerous small expenditures do matter, and they shouldn't be neglected. That's good budget management. But identifying and optimizing the few assets and liabilities that determine most of your overall financial success — that's good financial planning.
Can you think of any other ways to maximize the value of your retirement savings and real estate? What are your other high-impact assets? Are you taking steps to optimize them?
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