Opportunity Cost: What is it?
Throughout the creation of this website, we have talked a lot about opportunity cost without taking the appropriate time to really define what it is and how it relates to financial independence.
So what is it? The dictionary definition is “the loss of potential gain from other alternatives when one alternative is chosen”. I think a more working definition is that opportunity cost simply represents a sacrifice that must be made when one choice is made instead of an alternative one.
For every decision or action that we take, something needs to be sacrificed for that decision whether it be time, money, or other resources. And because these resources can always be put to use for other actions or decisions, when determining opportunity cost, it’s important to look at the value that each of these decisions or actions brings to our lives. So to best determine opportunity cost we need to first define what it is we value in life.
Time and Money
Personally, I look at opportunity cost in two major ways as it relates to financial independence: Time and Money. Although there are many other ways opportunity cost can be talked about, these are the main two in which I plan to discuss as it has the most impact on my life currently and the two often go hand in hand as you will see.
As mentioned many times before, I believe that time is our most valuable resource we possess. We only get a finite amount of it every day, so how we split up that time becomes the biggest decision we make most days.
To broaden the scope further, we also only get so much time to live, so much time with our parents, and so much time with our children still at home. So you can start to see how precious this resource truly is.
Money on the other hand, does not have a finite limit. Potentially, we can always earn more. save more, or spend more. This doesn’t mean we all have an endless supply of money, it just means that we never are limited to the amount we can earn where as we are limited to the amount of hours in our day.
Where time and money meet is when we understand that we can always trade time for more money. And where financial independence begins to creep in, is when we begin to understand that we don’t want to trade all of our time to meet the financial level needed to support our lifestyle. This is where opportunity cost begins.
An Example: Buying a House
Let’s start with an example to show what I mean.
So what are the main things we are told to do in life. I’d argue the majority are told to: go to college, get a job, get married, buy a house, and have kids.
But for this example, let’s focus on the house. When we go and get approved for a house, we are given the maximum loan for a house that our current income can afford. So many people then go out and purchase said house.
Where the issue lies, is when we don’t think about the value that this purchase brings, because by agreeing to this loan likely on a 30 year mortgage plan, not only did you agree to pay the money and the interest payments, but you also agreed to trade your time spent on work for the next 30 years to be able afford this house year after year.
So the opportunity cost for this decision is the money which could have been used for other purchases, investments, or opportunities. And more importantly the 40 hours a week, 52 weeks a year for 30 years of your life needed to pay for this house. Not to mention the time cost you now agreed on in order to clean a larger house, mow the lawn, or shovel the driveway, etc. But that’s besides the point.
See because if you didn’t have your job, you wouldn’t be able to afford this house. Where as instead, had you choose to rent or buy a smaller house. The opportunity cost also decreases as you now can trade less of your money and time to afford this house.
Leaving you more time to explore other money making opportunities, or spend with your family etc. Time is often the hidden fee we forget about when we make a decision.
Value
However, as I mentioned. It is about value. So at the end of the day, if you deemed that the value of a larger home is worth this cost. Then you made the correct decision.
You may be someone who finds great value in the ability to entertain at home, live in the best school district, have a large lawn to play with your kids in, or even if you believe the property will appreciate significantly with time, then the opportunity cost is negated by this perceived value.
On the flip side, maybe you made the decision to purchase this house due to the social pressure of your friends and family. Or you got a raise and felt obligated to upgrade your surroundings.
However, when you look at what you value, you discover that you value creating experiences with your family and would be perfectly happy in a smaller house with more disposable income and time to spend seeing the world with them.
It’s not to say that you can’t travel when you own a larger house. It’s only saying that by spending your time time and money to own the larger house, you have less time and money to spend in other areas of your life.
Every decision we make has a cost.
Opportunity Cost and Education
Opportunity cost also affects us when we think about education. Because when we decide to go to school, we are assuming that the increase in pay will pay for the time debt this decision has. In other words, by investing our time to go to school, we assume we will make more which will allow us to retire earlier or live a better (more expensive) lifestyle. However, what we find, is that this often isn’t true.
For example: Person A takes home $30,000 per year take home starting at age 18, where as person B went to college and makes $50,000 per year starting at age 22.
Assumptions:
- Savings Rate: 20%
- Education for 4 years: $40,000
- Interest Rate: 4.53%
- Return on Investment: 7%
Person A Retirement Age: 48 years old
Person B Retirement Age: 56.5 years old
Again, disregarding the perceived value of getting an education. When we strictly look at the opportunity cost of not being able to invest for the 4 years while going to school nor for the 4.5 years needed to pay off your school debt, we see that person A actually will be able to retire first.
And again, this isn’t to say person B couldn’t just increase their savings rate to retire at the same age. It’s strictly pointing out the fact that like all things school has a financial but more importantly a time cost to it that needs to be baked in to everyone’s decision.
A Basic Example: Eating Out for Lunch
Let’s say you eat out for lunch at work two days per week which costs you around $25 dollars, which doesn’t seem like much at all. Over a year, this costs you $1,300. Instead, let’s say you brought a lunch every day, so for those two days it cost you $5 dollars or $260 per year.
So let’s say you invest that difference instead of going out to eat. Let’s assume 7% return on investment as you are smart and invest in low cost index funds. After 30 years of working, this money has now accumulated to a whooping $105,110! Which if you lived on $30,000 a year decreases your retirement age by just over 3.5 years…
Can you see the opportunity cost now?! By going out to eat twice per week, you not only paid the money initially for the meal, but you also lost out on the opportunity that the money had to earn you more money in the future. On top of this, you also lost out on the time cost of needing to work longer before retirement.
Again, eating out for lunch does have a perceived value to it, but I can’t see many people agreeing to trade over $100,000 and 3.5 years of work for it.
Changing Our Perception
Most of use don’t think about opportunity cost on a daily basis. We see a $12.50 meal as very affordable and reasonable, which it is, so we make the purchase. I do the same, but the key difference is, is that I don’t do this day after day, week after week, year after year.
Yes, these small purchases don’t have a large effect on our bank account on a daily level but on a larger level they can begin to have massive effects due to the opportunity cost each decision has.
It’s okay to make purchases on things we want or value, where the problem lies is when we begin to be careless with our money and spend within our daily routine. This is where the compounding interest of opportunity cost hits us the hardest.
If we can begin to identify some of these routine purchases, we can begin to target ways to combat them. Maybe instead of the daily $5 dollar Starbucks, you invest in a high end espresso maker. It will pay for itself within the year, still provide you with the value of your daily coffee, and decrease the opportunity cost Starbucks was having on your life. Win-Win-Win.
Conclusion
At the end of the day, it truly is about the value of every decision we make. I’m not trying to discourage people from spending their money or using their time how they want to. I merely am encouraging people to look at their resources differently and to think about the effects of each decision has on the bigger picture in their life.
Thanks for reading, as always, feel free to comment with any questions or thoughts. If you have any specific questions, feel free to contact me here.
