How to stay ahead with Pareto on your side
04 Jul 2015
By Shadforth Financial Group
Vilfredo Pareto's vegetable garden was fertile. So fertile that it threw up a theory that has held for more than a century and across many walks of life.
Pareto, the Italian economist and philosopher, has a place in history as the person who identified the 'Pareto Principle,' otherwise known as the 'law of the vital few.' In Pareto's garden he saw that 80 per cent of the peas were produced by just 20 per cent of the pods. This led to his principle that 80 per cent of effects come from just 20 per cent of the causes.
The Pareto Principle holds true in many areas – it certainly applies to personal finances, although the 80:20 ratio is more like 95:5. That is, 95 per cent of the rewards come from five per cent of the factors.
So why do we get so distracted by things that don't matter? Firstly, it's human nature to get distracted. Secondly, there are multitudes of finance and media outlets providing distracting information.
Instead of trying to keep up with the 95 per cent, stay focused on that five per cent that makes all the difference by keeping to some basic rules:
- Begin with the end in mind. Many people aren't as clear on this as they should be. What do they want from their finances? It's a question that has to be answered before decisions can be made.
- What resources are available to you? This is a no-brainer. You can't plan without knowing what you've got today and what you're likely to earn in the future.
- Be crystal clear about your approach. This is a must. Make a plan either on your own or with professional assistance – then stick to it.
- Be conscious of what you spend. Another no brainer, but so many people struggle with this one.
- Use optimal structures to minimize taxes and reduce costs. Remember, every dollar you pay in unnecessary costs and taxes is one less dollar working for you.
You may have noticed that I didn't mention investment portfolios in that list. That's because, in many ways, they're part of that 95 per cent of factors that contribute less to the outcome than you might think. The financial press, even the nightly news, focuses on this area because it's interesting and can often be dramatic or entertaining. Yet successful investing isn't entertainment – it's much more likely to be boring.
An interesting fact from the United States is that there are now more managed funds than there are stocks. Managed funds, packaged and sold as the next big thing, are bait for the flighty - and the flighty are more likely to overreact to market movements or dramatic news. Many people overreacted during the GFC and pulled money out of the market and then faced an almost impossible dilemma: when to put their money back in?
I know a few people who sold at the right time – maybe you do too. But I don't know anyone who also went back in at the right time. Those who stayed the course, stuck to their strategy, rebalanced regularly, continued to save and didn't make short-term decisions are, in most cases, better off now than those who took their money and ran. Most importantly, they remain on track to achieve their personal goals and aspirations, which is what investing is supposed to be about in the first place.
A final point on the five per cent: the single most important factor in determining your level of personal financial success is simply how much you save along the way. More is better than less, as much as you can is better still. If you put more away, you will finish with more than someone who puts away less and tries to make up the difference with year after year of big investment wins.
That's just how it is – and it's also how it should be.
If you are seeking financial advice please contact us on 1300 308 440 or enquire online.