Opportunity cost is something you deal with on a regular basis. Imagine this scenario in your mind. You were just told that you are being given a gift of $5,000. You can use it however you like. As the possibilities begin to swirl in your mind, you know that a big decision is coming. Should you pay off $5,000 in debt, or go on that resort vacation you have been dreaming about? Should you use the money to buy a boat, or invest it and let it grow for 30 years? These are all important decisions to think about. This is a great example of how opportunity cost affects your financial decisions.
Opportunity cost involves thinking about the alternatives. Every day we are faced with decisions on how we spend our money. Opportunity cost and investing are often closely related. I am sure you have seen charts where you see the results of investing a small sum of money. When you factor in compound interest, chances are that money would grow significantly. Using the scenario above, what if you were able to get 8% interest on your investment? That $5,000 would turn into $50,313 in 30 years. That boat may not seem so appealing, right?
Opportunity Cost – Finding a Balance
However, not everything in life comes down to opportunity cost and the return on your investment. You have to live your life in the present and also plan for the future. If you are a miser for your entire life and just pack away money for the future, you might be missing out on some awesome experiences. If you come to the end of your life, would you be happy looking back? What good would all that money do for you if you weren’t able to experience life to the full? These are all important decisions we face throughout life.
Like so many things in life, balance and perspective are crucial. Let’s use another example. What if at 21 years of age, you were given a choice. For 5 years, you could receive $5,000 a year to invest, or you could use the money to go travel abroad and see the world. You know in your mind that you could get a great return on that money. If you let it sit and grow for 50 years at 8%, you would have over a million dollars at age 71. Seems like a good deal, doesn’t it?
Opportunity Cost – Not Just Simple Dollars and Cents
If only life worked that way. At 21 years of age, it’s likely a person has freedom and opportunity. As you get older, get married, start a family, your values and priorities change. You might have one chance in your life to freely travel abroad and see the world. What if it truly is a once in a lifetime opportunity? You know that you have a lifetime ahead of you to earn money and build your net worth. That decision is not so cut and dry, is it?
Make sound money decisions is important for all of us. However, life does not come down to simple financial transactions. All of us have unique needs and desires. You have the personal freedom to decide what is important to you. I always like to use the game of golf as an example. I love golf and could spend everyday out on a golf course. Meanwhile, many of my friends think it is boring and a waste of money. For them, the thought of spending $50 on golf is ridiculous. Meanwhile, they are busy pursuing hobbies that I have zero interest in. When something has meaning to you, opportunity cost takes on a whole new definition.
Weighing Opportunity Cost on Big Ticket Items
There are times I think it is more important to weigh the cost of a financial decision. The bigger the expense, the more we have to consider the desired outcome. For example, I have a big family from Germany and I love German cars. I really love the engineering and the driving experience. However, German cars are expensive in the United States. With my long term financial goals in mind, I have to weigh the pros and cons before making a decision. Do I go after the “Ultimate Driving Machine”, or do I drive something cheaper to operate? Am I willing to spend the extra money for the payment and insurance? In my case, the answer is yes! I found a great deal on a nice used BMW under warranty, and I love driving it. But, I waited many years to finally make the purchase.
When considering a house purchase the stakes get even higher. Buying a house is the biggest financial decision most of us will ever make. There are a lot of factors that come into the decision. Family considerations, location, size, cost – the list goes on. One of the things I see in my work is people that have too much money tied up in their house. Because of their financial situation, their budget is too tight every month. The house obligation prevents them from achieving other financial goals. When considering opportunity cost, the house becomes a financial burden instead of a blessing.
Opportunity Cost and True Wealth
It’s interesting seeing the tiny house movement. People are downsizing to minimize their living expenses. I am not saying you and I should rush out and buy a tiny house. That lifestyle takes a special set of circumstances and a strong commitment. However, I think all of us can gain good food for thought. It’s important for all of us to decide what is truly important to us. We have to personally give consideration to what true wealth means. Finding a balance might mean making sacrifices in other areas of our life.
Seizing the Opportunities in Life
I hope you find a balance with opportunity cost in your life. All of us need to consider the pros and cons when spending money. At the same time, life is so much more complicated than a bunch of financial transactions. We have to find a delicate balance of enjoying the present and planning for the future. Throw in mistakes and poor decisions at times, and it can get even more challenging. The good thing is time is usually on our side. We can usually clean up financial mistakes, but we cannot buy more time on this earth.