web analytics

Opportunity Cost and Personal Finance

When you spend money, you’re not just parting with cash on hand. You’re also taking a lot of other things that money could have gone to off the table.

That’s the basic idea behind “opportunity cost.” A great way to think about it in regards to financial literacy, and a good definition would be spending money on one opportunity means having to take a pass on others. In terms of personal finance, opportunity cost usually refers to the financial gain you could have made by choosing one option over another.

It’s not worth beating yourself up over money spent on absolute necessities – things like housing, food and so on. But opportunity cost is very important to think about when it comes to “discretionary spending,” or your “wants” It is something to think about before spending money on optional entertainment, travel, time wasters, fun, and similar items. Recognizing moments of opportunity cost is a key skill in managing your long-term financial health. Opportunity cost will also help you when investing in assets, whether financial or personal goods. Or learn about limiting depreciating assets in order to help build wealth.

Thinking About Opportunity Cost

There is a famous quote from Ben Franklin that is widely regarded as the foundation of the concept of opportunity cost, in which he advised readers to “remember that time is money.”

The Franklin quote puts a special emphasis on “idleness” as a lost opportunity to earn income for future needs. A good modern example would be a kid or teeanger buying a video game. The money that went to buying the game is a type of lost opportunity cost, but so is the time spent playing it. For example, studies show that kids tend to spend about eight hours a week playing the hit game Fortnite. That adds up to about 34 hours a month, or a little over 400 hours per year, of time that is not going to anything that is preparing them for their financial future. They would have worked, saved, invested, and even took classes on financial literacy instead of playing games. Even tell your kids about financial literacy themed games.

All of this is not to say that no one should ever have fun, or never spend discretionary income on entertainment. Having fun and relieving stress is an important part of life, and something that can even enhance your overall productivity. However, the difference between people who are prepared for their financial future and those who aren’t usually comes down to the ability to control discretionary spending and think about opportunity costs.

Professional football players as well as other examples are a great example. There are no end of players that made millions of dollars while they were on the field, and then turned around and spent nearly all of it immediately. Each time they made a decision to spend on “wants”, and each time they did not think about the opportunity cost of that spending, when they failed to do those things it hurt their long term financial stability.

Opportunity cost - saving vs. spending

The career of even a talented NFL player or any athlete can last just a few short years due to wear-and-tear and injuries. Once that brief career is over, many players find themselves in a financial shambles. They have a load of debt they have no means to repay, assets that they cannot afford the upkeep on, and expensive tastes that very suddenly have to be abandoned. The players that thrive once off the field tend to be those that developed other skills and made smart investments during their playing years.

Opportunity Cost in retirement planning

Most of us will never have to deal with the extreme highs and lows of a professional athlete, but we all have to think about a future in which our ability to work for money is diminished.┬áRetirement planning is an excellent place to start thinking about financial opportunity cost. Let’s think about the small payments you might put into a retirement fund as a young person. At the time, retirement seems far away and the payments seem to be so small and meaningless. It’s very tempting to just spend them on something fun instead.

The “opportunity cost” here is not just one of those small payments, however. It’s one of those small payments after accruing decades of interest. It is the compound interest and growth of that money that was given up. Opportunity cost applies to choices to put off payments as well. The debts you carry are generating interest for someone else; a smaller payment deferred today usually translates into a larger payment tomorrow.

Let’s say that at 20 years old, you begin putting $20 per month away for retirement. A simple certificate of deposit would yield about 2% interest. Each of those $20 payments would more than double to about $49 in total value after 45 years. Not tempting enough? Let’s say you invest in a stock based investment instead, which would be expected to gain about 8% on average per year (of course some years are less and some more). That makes the eventual value of each of those $20 payments a whopping $638. Not a bad start, and you can always increase those payments as your ability to earn goes up over your adult life. Learn how compound interest works.

Opportunity Cost and Education

It’s just common sense that you would want kids thinking about their future education as early as possible to maximize their opportunities. However, it’s also worth thinking more carefully about the conventional advice to get into a “good college” in an in-demand field.

Let’s say that a parent pushes their child to get into a top medical school, not caring overmuch if the child actually wants to be a doctor. All of the time spent on that goal represents an opportunity cost, one that might be quite heavy if they drop out of medical school halfway and have to start all over.

Parents always want financial security and as few hardships as possible for their child, but the fabled “good college” degree might not be the right path to that. How likely is it that the child will actually be accepted to a top school? How likely are they to maintain interest and be able to perform well enough to make it through training? How much debt do they need to take on?

Financial security can be had in a number of other ways that have lower barriers to entry, a greater likelihood of success and more in tune with the child’s natural inclinations and drives. For example, trade apprenticeships lead to high-paying jobs and are much more available than elite college degrees. To turn our video game example from earlier on its head, a child might even have a viable career in esports if they’re good enough at the right game!

Opportunity Cost and Investing

The principles of retirement planning we discussed earlier can be applied to more general investing as well. The general idea being that a small investment that seems trivial now can balloon to a significant amount of money if left alone for long enough.

Here’s one example: in 2011, it was so hard to get people to try Bitcoin that there was a “faucet” website giving one away for free each day to anyone interested. If you had spent the minute to click on that link then, you would right now have about $8,000 for each of those minutes of work. If you had sold your coins at the peak in December 2017, it would have been about $19,000 for each minute! While that is a risky investment from the financial literacy perspective, it is an example.

But here maybe the ultimate example: If a teenager starts investing at age 18, and only invest $1000 per year, they can be a millionaire by the time they retire! If they earn 8% per year on the investment, they will be a multiple millionaire by the time they are in their early 70s. How is that for an example comparing the opportunity cost of saving/invest vs. spending.

Small payment today, big opportunity cost tomorrow

All of this is intended to get you thinking about long-term opportunity cost and value of actions and financial choices. The people who best anticipate these possibilities are usually the ones that are most secure financially later in life. Think about what you give up tomorrow, and your long term financial health, when you spend money today.

By Jon McNamara