"The best is the enemy of the good."
"If the world were perfect, it wouldn't be."
The printer is out of ink. Ugh! Now I have to replace it. I wonder how many people knew it was out of ink but let it sit, waiting for me. I pop in the replacement and my article prints. I'm fascinated by an article written by Tim Ferriss, called The Top 5 Reasons to Be a Jack of All Trades. I've often thought that I was pretty good at quite a few things, but the best at nothing. The gossip seems to be that everyone should specialize, though. That's where the money is, they say. Pick something and be the best at it. Not only does that go against my natural curiosity, but it doesn't sit right, but I don't know why.
The article is a bit of confirmation bias, because like everyone else, I want to be able to say, "that's exactly what I've been thinking...only articulated better!" In the article, Tim talks about how the phrase "jack of all trades, master of none" is nonsense. He talks about how people who know a little bit about a lot of things see relationships and the big picture better. Finally, he talks about his wide use of the 80/20 rule.
It gets me wondering about how the 80/20 rule could apply in personal finance.
The 80/20 rule (actually called the Pareto principle) is the idea that 80% of outcomes come from 20% of the inputs. Some examples are that 80% of most companies' productivity comes from 20% of their employees, 80% of a language comes from 20% of the words, and 80% of activities like sports or dancing come from 20% of the moves. In short, 80% of the mastery comes from 20% of the effort.
This is a good deal and gives you the biggest bang for your buck.
The final 20% takes more time, money, and energy. This is what economists call diminishing returns (or if you are a nerd, the law of diminishing marginal utility). This is the part of the curve where professional athletes live. They were 80% up the curve by the time they were eight. They make their money by climbing the rest of the way.
This does not give you the bang for the buck you got on the 80% part of the curve. The good news is that, unless you have a specific reason - like professional athletes - there is no need to put in the effort to get there. You are free to spend your precious time and energy on getting 80% of the way up your next endeavor.
80/20 in Personal Finance: Rules of Thumb
In personal finance, we use the 80/20 rule to create rules of thumb. Rules of thumb are rules that are meant to be general advice that's easy to remember and will get people most of the way to where they need to go.
As we think about rules of thumb for people, it's helpful to think about ye olde bell curve. People (however you organize them) will generally resemble a bell. Most people are in the middle; they are average. On the ends are the exceptions; people who have something unique about them.
Since there are more average people than non-average people, by definition, there are more of them. That's what the middle of the bell curve represents.
The bell curve could represent people's financial circumstances, where a particular rule works for average people but not for people who have overly complex situations. Alternatively, the rule of thumb might not be a good idea for someone who doesn't have any complexity in their situation and doesn't need any advice or rule.
Everyone Has an 80% Solution
Just because a particular rule of thumb doesn't apply equally to everyone doesn't mean that there isn't an 80% solution for everyone. Everyone has an 80% solution, even if it's not the general rule of thumb that applies to everyone else. Every person can benefit from getting 80% of the way there with 20% of the effort.
I firmly believe that there is no one-size-fits-all advice. As such, I want to take a few sentences to differentiate one-size-fits-all advice from rules of thumb. For starters rules of thumb don't work for everyone. Remember, they are less likely to work for people on the ends of the bell curve. You can recognize one-size-fits-all advice by how the advice starts. "Everyone should...," "you need to...," or "I can't believe you don't..." are pieces of one-size-fits-all advice.
The speaker, or writer, might be confused, talking about a rule of thumb but presenting it as universal advice. Now you'll know the difference.
Rules of Thumb Examples
Some examples might be helpful for you to think about rules of thumb.
Uses of Debt: One rule of thumb says that it's okay to use debt to pay for appreciating assets, but not for depreciating assets. In other words, there is good debt and bad debt.
Okay, so what's that mean? An appreciating asset is simply an asset (something that you own) that will appreciate (go up in value). A depreciating asset is the opposite. It's something that you own that will go down in value.
Therefore, according to this rule of thumb, it's okay to purchase a college education with student loans, because the value of that education will be worth more than what you paid for it, and you can sell your time, skills, expertise, and talent for a premium.
Similarly, it's okay to purchase a house with a mortgage. The house is expected to go up in value, at least by inflation and hopefully more (note: this applies to owning the house for long periods of time - house values can go down in the short run).
On the other hand, the rule says you should not buy furniture, electronics, or alcohol with your credit card.
Since it's a rule of thumb (and not a law), nothing here suggests that these tips would work for you. It is entirely possible that paying off a mortgage or buying a house with cash is the best option. It's possible for you to take out too many student loans. And putting purchases on a credit card might be part of a bigger financial plan. That's why it's a rule of thumb and not one-size-fits-all advice.
Some people might read that and think it's okay to splurge on purchases and trips that will have value to them that is greater than the cost. They'll say, "The rule of thumb says that if something will go up in value it's okay to use debt. My 3-month vacation will be worth a lot to me. Therefore I can use my credit card."
This is wrong; it's flawed logic. The "value" of the trip is subjective. You can't sell that to someone else.
Buying an appreciating asset can be thought of as investing. Buying a depreciating asset is thought of as an expense. The idea is to not go into debt for expenses.
Maximum Student Loans: This rule of thumb states that you should not take out more in student loans than you expect to make in your first year on the job. Throughout your career, you'll earn raises and promotions. It can be easy to fall into the trap of thinking that you can use lifetime earnings or an estimated 10-year salary figure to determine an appropriate amount of student loans.
But that's a ticket to too-much-debtsville. The rule helps by saying that if you expect to make $35,000 per year when you get out of college you should not graduate with more than $35,000 in student loans. If you expect to make $60,000 in your first year then you should not graduate with more than $60,000 in student loan debt.
This little idea helps prevent people from taking out $60,000 in student loans to get a degree in fine arts, where it's difficult to find a $60,000 per year job. It's unlikely to be a good investment. That same $60,000 student loan bill makes more sense for an engineering major, however.
Again, it's not a law. There are people for whom this rule doesn't apply. But, that's the brilliance of rules of thumb - they work for most people.
Savings Rate: How much of your income should you save? The rule of thumb on this one isn't clear. Some say it's at least 10%, some say it should be more than 15%. I'll lump savings and investing together and call it 15%. The more automated this is, the easier it will be to do. Pay yourself first and spend the rest.
Just like all rules of thumb, this one's not perfect. For example, assume you have a lifestyle you are comfortable with. If you get a raise and continue saving 15%, even after taxes you'll have more money to spend. But since you already like your lifestyle, more money wouldn't help you, but it would be easy to spend. This is called lifestyle creep. You can combat lifestyle creep by increasing your savings rate with raises, so you'd be saving more than 15%.
Alternatively, there are people for whom saving 15% just isn't possible right now.
Focus On You
What works for others may not work for you, and what works for you may not work for others. Don't put off doing something because it's not perfect or optimized. Start with rules of thumb and adjust them where necessary. You can get most of the way there with a little bit of time and effort. Then you can make it better. Or, you can live your life and let your "good enough" personal finance system run in the background.
You only have one life. Live intentionally.
Farnam Street: Mental Models
Brad Klontz, Ted Klontz: Mind Over Money
Sarah Newcomb: Loaded
Carl Richards: The Behavior Gap
Carl Richards: The One-Page Financial Plan
Wikipedia: Marginal utility
Wikipedia: Pareto principle
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