Anyone who has spent any time pondering their finances is familiar with the concept of “opportunity cost”. Here is the definition according to the Oxford dictionary:
“The loss of other alternatives when one alternative is chosen.”
Simply put, it is your inability to make a different choice once you have made one. For example, once you have booked your vacation for skiing in Tahoe, you lost the opportunity to book a trip to Hawaii. This can be a powerful way of thinking about money and wealth – by framing up what you can no longer do, once you make a decision with your money.
Often the opportunity cost concept is abused by the financial press. If you are like me, you are probably tired of hearing about the “Latte Factor”. This is the tired story where if you skip your daily $5 latte, you can amass a multi-million dollar retirement portfolio. This is simply a false tradeoff in my mind. While thriftiness is desirable, I have not met many people where small dollar savings has been a key to a person’s financial success. Driven to its extreme, opportunity cost thinking can lead to a crazy focus on the minutia of budgeting. The phrase “penny-wise but pound foolish” springs to mind. If you focus too much on opportunity cost in your personal life, you can drive yourself crazy. I call this “the cost of opportunity cost”.
Where I think opportunity cost analysis works best is with the big financial decisions in your life. I think it works particularly well when you have a good handle on your personal or family values. I find, for most people, the big financial decisions revolve around a triumvirate of issues: house, cars and education. If you get these big decisions aligned to your values, then you are well on your way to financial success.
I will use an example from my own life: housing. Housing is expensive in California. We live in a very small house for four people. On one hand, we live in a lovely neighborhood, with great neighbors in a climate that is as close to ideal as I’ve ever experienced, so we enjoy a lovely indoor/outdoor lifestyle. And we can comfortably afford our house. On the other hand, it is 1,400 square feet and we have two children. We used to watch the show “Tiny Houses” until we realized we are that show. We would love an extra bedroom for when family visits, a bigger kitchen and more storage. Based on Colleen’s nightly research on Redfin, it would probably cost us at least $500k additional to find a house that met our criteria (it is California). We estimate this would cost about $3,000 in additional mortgage, tax and insurance costs. Our family values financial flexibility and travel among other things. If we don’t spend that $3,000 a month on a mortgage, we could, for example, put up our visiting parents at the four-star hotel nearby – for 10 days every month! Or we could rent approximately 20 storage units, or potentially eat out for dinner (to escape our small kitchen) for 15 out of 30 nights in the month. Or we could take a nice vacation, literally, every month. Faced with those types of opportunity costs, we chose to stay where we are and spend generously on the things that we truly value.
This is the type of thinking that everyone can apply to their life with very powerful results. Everyone is different. We all weigh opportunities differently because different things are important to each of us. But used appropriately, the concept of opportunity cost can help us make important decisions and still live the type of life that has meaning and value to us.
Now it’s time for that coffee…
Note: The contents of this site are general in nature and not intended as specific investment advice. All investments are subject to risk; including loss of investment value. If you have any question regarding investments or concepts in these pages, please consult with an investment professional.