Putting some money away for a rainy day is a big challenge for many. This is partly because some are not making enough or as much as others while others simply do not know how to plan.
It is the reason why financial experts for long spread the gospel of saving advocating for rules such as the 50/30/20 and the 80/20.
These rules are meant to guide anyone who makes money at the end of the day to ensure they do not spend it all but put aside something for the future.
In this article, we explore the 50/30/20 and 80/20 rule with insight on which of the two works best depending on your income level or spending habits.
You will get to learn why the 50/30/20 rule does not work if you are a low-income earner and how the 80/20 rule while not scientific, is good for those who do not want to get into the nitty gritty details of budgeting.
50/30/20 rule of thumb
If you are familiar with American politics, then you are aware of Senator Elizabeth Warren. She is regarded as the amplifier of the 50/30/20 budget rule in finance which she did through her book: All Your Worth: The Ultimate Lifetime Money Plan.
Whenever you hear a conversation about financial planning, budgeting or personal finance, this is the rule you are most likely to be offered as a solution to your ailing money life.
The 50/30/20 budget rule dictates that 50 per cent of your income goes to spending, 30 per cent on investments and the remaining 20 per cent on savings.
“That usually guides you to know if you spending beyond your means,” says Kevin Muriuki, financial and business expert.
Forbes.com explains that one of the attractions to the 50/30/20 rule is its simplicity. It goes ahead to give an example of an individual who earns Sh50,000 where half this goes to spending where mandatory expenditures fall, Sh10,000 on savings and debt repayment if any and Sh15,000 on wants.
There are circumstances however where this rule does not work. These are people with low incomes.
“Although the 50/30/20 rule may be a good rule of thumb for individuals, it can be unrealistic for those with low incomes or those who live in areas with high living costs,” says Forbes.
It however encourages the use of this rule for those who want to get into the habit of savings and consistently paying up their debt.
“However, following the bucket allocation percentages to the exact amounts might not be realistic, based on your income and how much your necessities cost,” it adds. “This is not to say this method of budgeting is not useful.”
It adds that using this method will enable you to know which areas you have been overspending.
“You realise you spend too much on subscription or dining out and use that information to make adjustments,” it advises.
80/20 rule of thumb
Just like the 50/30/20 rule, this as well has an emphasis on saving. This rule provides that 20 per cent of your income should be put away as savings while the rest (80 per cent) for spending.
This rule appears to be more blanket on how you are going to spend on the bigger portion of your income as such one may not be able to clearly track how the money is utilised.
It fits well with the kind of people who demand to pay themselves first and non-believers in budgeting.
The 80/20 Rule of Thumb of Budgeting, an article by thebalance.com. a personal finance education platform, describes this budgeting method as a simple way to achieve financial stability as it ensures you have enough savings for a rainy day.
The article says this rule is a simplified version of 50/30/20.
“The 80/20 rule of thumb is the best for those who don’t need or want structure, who don’t like to track their spending, or who are new to budgeting,” the article reads.
“It is a simplified version of the 50/30/20 rule of the thumb, which allocates 50 per cent of your take-home pay to needs, 30 per cent to wants and 20 per cent to saving.”
This article explains that ideally, once you get paid, you immediately put 20 per cent into saving.
“The goal of this budget is to ensure you always pay yourself first,” reads the February 2022 article.
If you are practising 80/20, it means once you save 20 per cent, the rest 80 should cater for all of your needs, wants like rent, food, entertainment and other expenses.
The genesis of the 80/20 rule in budgeting is the Pareto principle. This principle state that 80 per cent of outcome in life stems from just 20 per cent of causes. Vilfredo Pareto, an economist in the 1800s in Italy in the brain behind this principle.
His thinking was largely from observation where it is documented that he realised 80 per cent of land in Italy was owned by 20 per cent of the population. He also observed that 80 per cent of pea pods in his garden was from 20 per cent of plants.
The 80/20 rule was then largely used in human resources, time management, and has also found itself in budgeting and investment.
While this rule may make sense in other fields despite its limitless applications, is it really suitable when it comes to personal finance?
Businesinsider.com notes that the 80/20 rule is not a mathematical law and is not backed by any scientific evidence but rather anecdotes.
It adds in the August 2022 analysis of the principal, that it is mere coincidence of two double-digit numbers that adds to 100.
The analysis titled ‘What is the 80/20 rule? Understanding the economic meaning at the Pareto Principal’ says this rule can be used as a measure of evaluation but not prediction.
As such, as an investor, it is not guaranteed that 80 per cent of your returns will stem from just 20 per cent of your investments.