What is Opportunity Cost?
- Opportunity cost is all about the choices you make and their impact on your financial future
- It represents the cost of choosing to spend money instead of investing it or investing in an inefficient manner
Opportunity cost is a fundamental concept to financial analysis and this includes personal finance. Understanding opportunity cost and applying it to financial decision making will open your eyes to new ways of thinking about money.
The concept itself is simple. You have limited resources(money) with which to make purchases and you must decide how to spend it. If you spend your money on one opportunity you won’t be able to spend it on other opportunities and this is the cost of that choice.
Opportunity cost is all about choices
Your life is a series of choices and personal finance is no different. You only have so much time and so much money. Even Jeff Bezos has limitations(though not as many as most of us). At its core, opportunity cost is about understanding the impact of your choices.
Every time you spend money on something, whether it is a new car or an investment, you forgo the ability to spend it on something else. You make the choice between the different alternatives and now you have to live with the consequences.
Sometimes these choices can be difficult, perhaps not like choosing between the red pill and the blue pill, but difficult nonetheless. Understanding opportunity cost and applying it allows you to start thinking of financial choices in terms of their consequences.
When is it useful in personal finance
Opportunity cost is often used to compare competing investments. A purchase of real estate instead of a purchase of stocks for instance. These comparisons generally revolve around the difference in the expected rate of return between investments.
You can also use it to compare spending to investing. There is an opportunity cost when purchasing a depreciating asset instead of investing the money. When you consider the time value of money you may be very surprised how much that new car today takes out of your accounts when you hit retirement age.
Using opportunity cost
- Spending vs Investing – Life will constantly confront you with the option of consumption or investing. You can choose to by a luxury car or you can choose to buy a compact car and invest the difference. You can use time value of money calculation on a purchase to find out how much money it ended up costing you at some point in the future, say retirement.
- Comparing Alternative Investments – Given finite money to invest, you must remember that any investment you make will cost you the opportunity of investing that money somewhere else. For instance, investing $10,000 in a CD at 1% or a high yield savings account at 2%. Since both options have similar risk, your opportunity cost for buying that CD is 1%.
Examples of Opportunity Cost
Let’s compare spending vs. investing as an example. Let us say you have just graduated from college. You took that first job and you are making $50,000 a year. Your net worth is still negative due to student loans, but you want to reward yourself anyhow for all of the hard work and sacrifice.
You decide you got buy yourself a nice new german car. The purchase price on a new BMW is $40,000. The expectation is to drive is for 5 years and then sell it for $15,000 meaning your total cost to own was $25,000.
Alternatively you can buy a used Honda for $15,000 and sell it for $10,000 after driving it for the same 5 years. The BMW will cost you $20,000 more than than the Honda. You could take that $20,000 savings and invest in an S&P 500 Index fund as well. You could expect to earn around a 9% return on it too.
So what is the opportunity cost of that BMW? It’s $20,000 right now, but what about in 40 years when you retire. How much will that BMW take out of your bank accounts at age 62? Assuming the 9% return, a simple compounding interest calculation says that $20,000 would turn into $628,189 over 40 years!
That is what opportunity cost is all about. The choices you make can have dramatic impacts on your financial future. Always weight investment opportunities carefully against your other options.
When you are confronted with the option of to consume or to invest, always thinks in terms of what that consumption will ultimately cost you. What seems like small amounts today can turn into overwhelming amounts in the future.
This doesn’t mean you should never splurge on extravagant purchases that make you happy, but it does mean you should do it with both eyes open to the trust cost.