Why Depreciating Assets Wreck Your Finances
Spending on depreciating assets can wreck your finances. Many people associate being wealthy with owning luxury cars, jewelry, designer jeans and high end watches. This is the image of wealth portrayed in the media and popularized in movies.
The material goods you purchase are really depreciating assets and they are very bad for your financial health. Every time you choose to make a purchase of a depreciating asset it comes at the opportunity cost of other assets that could be used to increase your net worth.
Over time compounding interest kicks in to turn modest spending into massive opportunity loss. This is how depreciating assets can wreck your finances.
What Are Depreciating Assets?
Depreciating assets are assets that drop in value over time. Examples include cars, boats, motorcycles, computers. As soon as you buy a depreciating asset your net worth starts going down!
Assets can also appreciate or go up in value over time. These types of assets are referred to as investments. Investment work to increase your net worth over time.
What is the Opportunity Cost of Buying Depreciating Assets
With every dollar you have comes the choice of what to do with it. You can choose to invest it or to spend it. If you choose to spend it, you exchange it for a good or service and it’s gone. The opportunity cost of the consumption was the investment that you didn’t get to make.
You have to spend some money to get through life. The problems arise when you spend much more than you need to for the good or service you want. This extra money spent adds up and compounds over your lifetime reaching dramatically large amounts in the future.
The Effect of Compounding Over Your Lifetime
The most powerful force in all of finance is compounding interest, or at least that is what Albert Einstein thought. I agree with him, and you know they say that great minds think alike.
So the reason Einstein was so fond of compounding interest is because it can turn small amounts of money into extremely large amounts of money over time. This means that seemingly inconsequential decisions can have a HUGE impact on your finances over time.
Examples of Opportunity Cost of Depreciating Assets
It can be difficult to really understand how much of an impact opportunity cost can have on your eventual nest egg. It can be helpful to look at an example. Let’s look at the impact of three choices to spend rather than invest on your long term net worth.
The Choices Made to Spend
- When you are 20 you decide that you need a new laptop. Your dad offered you his old one for free, but you decided to buy a $3,000 Macbook Pro instead. Opportunity Cost is $3,000 at age 20.
- Your finally graduate from college, and get your first real job. You could buy a $30,000 Honda Accord, however you instead decide on a $50,000 BMW. Opportunity Cost is $20,000 at age 25.
- At 30 you decide to rack up $10,000 in credit card debt on designer clothes and handbags. Opportunity Cost is $10,000 at age 30.
How Much Does All That Really Cost
You might look at this and say it all costs $33,000, but this ignores the compounding interest had you invested it instead! Let’s assume your alternative use for the money was to invest in a low cost index ETF that tracks the US stock market. Historically you could expect a 10% return over a long period of time when investing in stocks. Calculating it out it looks more like:
|Choice||Age 40||Age 50||Age 60||Age 70|
$3,000 at 20
$30,000 at 25
$10,000 at 30
Here is a chart for those of you that like a visual:
So these three decisions to spend $33,000 that you made between 20 and 30 might have cost you over $1 million by the time you turn 61 years old. If you plan on working to closer to 70 these choices would have cost you over $2 million! The time value of money can really have a major impact.
You must choose whether to invest or spend every dollar you make. Do so wisely because the cost of your choices can compound over time to mind bogglingly large amounts of money.
Learn to consider the opportunity cost of any item you want to buy today, not just it’s purchase price. Think of all your spending decisions this way and you can learn to make better financial decisions.