Everything has an opportunity cost. Whether it’s your next investment decision or simply picking what to order off the menu, there is always a tradeoff to make.
Understanding what opportunity cost is and how to incorporate it into your everyday life can help optimize your decision making.
Oftentimes, understanding opportunity costs is what allows people to be successful nimble investors, business people, and masters of their own finances. Those who understand opportunity costs are able to survey all of their options at once and make an informed decision based on the information available to them.
A basic example, and the one that resonates most with
One of the ways people become millionaires is by investing now! They consider the opportunity cost of that beer, movie, and fancy candlelit dinner, and choose to invest instead (most the time – we’re all human).
Beyond investing, everything from banking to credit cards has an opportunity cost. Being able to consider these opportunity costs will make you feel more confident in everyday decisions made your personal life – especially the big ones!
For those not familiar, as I was not a few years ago, let’s define opportunity cost. Then, we’ll dive into how it can improve your life in a number of different ways.
What is opportunity cost?
So, what exactly is an opportunity cost?
Investopedia defines opportunity cost as, “the benefits an individual, investor or business misses out on when choosing one alternative over another.”
That’s a good (and simple) definition. Even simpler, though, would be, “the missed benefit of the next best thing.” What are you giving up by choosing something?
Bringing opportunity cost to life
One easy example to help paint this picture would be: choosing a restaurant for dinner.
Let’s say you choose to eat at Chipotle. Great choice. You get a tasty burrito for $7.
If your next best option was to make a burrito at home with ingredients that would cost $3, then the opportunity cost is the difference between the two options: $4.
Though, there are more than just financial opportunity costs. There are also non-financial opportunity costs (go figure). The taste between a chipotle burrito and an at-home burrito is also considered. That’s probably why you chose Chipotle over eating at home in the first place.
With everyday decisions like the one above, we are all likely running scenarios through our head non-stop. We do this subconsiously.
Naturally, you’re thinking about what else you could be eating for dinner when making a decision (and the cost associated with all options).
Seems like a no brainer.
Though with a lot of big decisions, we often don’t pay enough attention to, as well as consider and analyze, opportunity costs.
Are you running through the right scenarios when deciding which car to buy?
Have you thought through all of your investment options before buying that stock for $1,000?
When choosing what to eat, the stakes are pretty low. When making large personal finance decisions, the stakes are much higher!
Opportunity costs in
There are four key areas of personal finance where you should be considering opportunity costs in all of your decision making:
- Investing (including real estate)
- Credit Cards
In each of the
Investing opportunity cost
The first step to any investment decision is to consider all of your investment options.
Sure, a 2% return from a bond sounds great when compared to a savings account that provides next to 0%. But compare that to an equity index fund that returns 7% on average and it seems terrible.
There are countless investment options available to you, but four main asset classes to focus on to help narrow your opportunity cost analysis at the beginning are:
- Equity / Stocks: Pieces of individual companies.
- Bonds: A loan you issue to a company, government, etc.
- Real Estate: Physical property.
- Cash: Money on hand or in a bank account.
Above you can see the ‘average return’ opportunity cost of each investment compared to each other. Assumptions are that equities return +7%, bonds and real estate +3%, and cash +0%. The blue area is the opportunity cost of equity compared to bonds and real estate. The green area is the opportunity cost of bonds and real estate compared to cash.
So far, we have looked at the financial opportunity costs to investment options. That is not the only opportunity cost to consider with investing though. Just like burritos have taste, investments have a risk .
Assigning risk to investment options is a little trickier than predicting return. With returns, you can simply pull the average return of an investment opportunity from history (that is usually the best measure of future success available). Looking at risk is harder, but you could assign risk a scale of 1-10. Adjust the numbers as you see fit (10 is high):
- Equity / Stocks: 7
- Bonds: 2
- Real Estate: 4
- Cash: 0
So, there is average return and risk. What else should we consider when viewing our investment options?
Here are the top 3 in my book:
- Average Return: What does this investment return on average (usually the best indicator for future performance).
- Risk: How risky is your investment (usually this applies in the short term, as long term returns are more reliable).
- Effort: How much time you need to spend on this investment.
There you have it, we just built our first opportunity cost framework for making decisions (in this case, investing). You need to consider what the effort is, risk and average return involved in the option you are choosing vs the next best option.
And if you think of another factor that is important to you, then add it to the framework above! It can be a living document to help you make smart decisions.
Investing opportunity cost 2.0: Real Estate
Time for investing 2.0, where we dive into the one asset class least like the others: Real Estate.
When buying a home (or piece of property), you do not simply deposit $1,000 into a fund and move on with your day (unless, of course, you are buying a REIT). Typically, you make a down payment, pay closing costs, and then pay your mortgage ongoing.
The opportunity cost of the down payment and closing cost is that you could have invested that money and earned roughly +7% in the stock market. Now it’s gone (well, the closing cost is gone, while the down payment went towards your new asset).
On the flip side, instead of throwing away $1,000 a month on rent (or however much monthly rent is in your parts), you are now investing it back into your house (assuming your mortgage and hypothetical rent are the same in this scenario, which we are).
Plus, hopefully the home (mortgage payments) are growing slightly in value.
To be perfectly honest, there are too many moving pieces to give a nice, clean answer on how to analyze the opportunity cost of buying a home vs renting. So instead, I built out this excel sheet which should help you come to an informed decision. Instructions inside.
Banking opportunity cost
Banking is one of the easiest places to optimize your opportunity cost thinking. For one, there are many options that are easy to rule out.
Do you plan to stuff your cash under your mattress? I hope not.
Are you going to put 100% of your savings in the stocks and bonds? Probably not (although, it might not be a terrible idea).
So, what do you need to consider when thinking through banking and saving alternatives? Largely, it comes down to two factors:
- Interest Rate: How much your bank pays you to store your money with them.
- Convenience: How easy it is to use the and access your money.
Of course, there are other factors to consider, like fees and minimum balances, but those are less of “tradeoffs” and more of “you need to have low/no fees and minimum balances to even be considered.”
When choosing a bank, know your options and what items to consider when examining alternatives. If you know which type of bank account you want, you can apply the same opportunity cost framework to the best banks and institutions you can find (i.e., Chase, Citi, Discover, etc.).
Credit card opportunity cost
Finding the perfect credit card is no easy feat. There are what seems like a million options, each offering different amount of points, miles
Mixed in with that are annual fees, lounge passes, varying APR percentages and other perks (and downfalls). Making sense of your options is next to impossible.
Oftentimes, to my dismay, I hear friends and family cheer about their $300 sign up bonus. Or their fantastic 1.5% cash back on everything.
Is this even good?
Sure, compared to paying cash and not getting anything in return, it’s fantastic.
Though, compared to their ideal credit card (the one out there waiting to be found) it may be terrible!
How do you avoid making the wrong choice? The same as before, of course. Know your options and build a framework.
With credit cards, you have two broad options: annual fee credit cards and no annual fee credit cards.
- Annual Fee Credit Cards: Credit cards that offer higher bonuses and perks, but charge an annual fee to use them.
- No Annual Fee Credit Cards: Credit cards that offer lower bonuses and perks, and in return have no annual fee.
There is a lot to consider when choosing a card, but the 3 most important factors to include in your framework are:
- Payback: What the credit card pays you ongoing (in the form of points, miles or cash back) minus any annual fees.
- Bonus: The one time bonus you get for signing up.
- Other perks: Other perks that are important to you like no foreign transaction fees and airport lounge access.
When choosing a credit card, know your options and what items to consider when examining alternatives.
everyday) opportunity cost
The budgeting category is the most complex when it comes to understanding your opportunity costs. Yes, even more complex that investing 2.0.
There is not a finite list of options in this category (like checking vs savings account, or annual fee vs no annual fee). Instead, that $10 you are spending on dinner could be going towards rent, groceries, a new phone, investments, or anything else you can imagine.
So, rather than build a defined framework for thinking through budgeting opportunity costs, a better strategy is to adopt a new way of thinking altogether.
One popular approach is to think of your money as time.
This is easiest to understand with an example. Let’s say make $10 an hour. When buying dinner for $10, don’t think about the monetary value of the dinner, think about how much time you would have to spend working to pay yourself back for that dinner. Which in this case, is one hour.
That $10 dinner’s opportunity cost is one hour of free time!
While you’ll probably still grab dinner, it might help you more thoughtfully think through if the $100 pair of jeans are worth it, or the new $15,000 car (vs the use $7,000 one). And so on.
Optimize your life with opportunity cost thinking
Now you know the easy steps to take to consider opportunity costs in your personal finance decisions. You are a better, more thoughtful
Just remember, there are two steps to understanding the opportunity cost of any decision.
First, layout your framework:
- What options are available to you.
- What factors are important to help make this decision (financial and non-financial). For example, with investing, average return, risk and effort.
Then, assign a rank to each framework.
Now, you have a baseline to make a decision, and options to compare against one another.
When choosing a stock, you’re not choosing against a baseline of 0% return, you’re choosing against a baseline of the next best option (like the S&P returning +7%).
About the Author: Just Start Investing is a personal finance website that makes investing easy. Learn the simple strategies to start investing today, as well as ways to optimize your credit cards, banking