When we make investing decisions, there is a cost that is frequently ignored. It is called opportunity cost and it is very real.
What is an opportunity cost?
It is the cost of the alternative that we didn’t choose. For example, if we are making the decision to buy or rent a house and we decide to buy. The cost of renting is some of the opportunity cost, but you can’t forget about the cost of not investing as well. By buying a house you are giving up the opportunity to invest your deposit in the sharemarket. If renting is cheaper than the mortgage on a monthly basis, you may also be giving up investing the difference. Don’t disregard these in your calculations. See my article on rent vs buy for a more in-depth analysis.
Let’s say you are looking at buying an expensive dinner out. You have narrowed the choice down to 3 restaurants, before making the decision on your favourite. Seems all well and good, but was there an alternative we forgot to consider?
Not going out to dinner is an option that wasn’t even considered. When we spend our money on something now, we are giving up something later. By buying dinner now for some instant pleasure, we are giving up on future savings. A $200 dollar dinner now could be worth over $1000 in 30 years’ time if we invested the money instead. Effectively, the dinner cost $1,000 of our future dollars.
You might think big deal. $800 loss spread over 30 years. I think I will be OK. The problem arises if we make ALL our decisions without consideration of the future opportunity cost. Our losses may reach the hundreds of thousands.
There may be room in your budget for BOTH an expensive dinner and to save as per your targets. Socialising with others at dinner twice a week may be more important to you than having money later in life. Eating out every so often may be important to you. Each to their own. All I am saying is at least consider the opportunity cost so that you can pick the options that will bring you the most progress towards your goals. Considering opportunity cost forces us to really think about our values, what is most important to us, and what we want to do with our money.
If we don’t consider the opportunity costs then it is hard to make an informed decision. It means we are not considering all the outcomes of the possible alternatives. This may result in making sub-par decisions that don’t reflect our real aspirations.
It is all well and good to say that if I don’t spend money here, I can invest it there. But life happens and it doesn’t always work that way. Things break that need repairing. We are also emotional people that don’t always think with our heads. We may delay spending on this occasion, but in a week or two there may be something else that attracts the attention of our wallet. There are people all over that are trying to get their hands on our money. It is tiring to say no all the time. Banks, insurance companies, marketers, volunteers.
This is why it can be difficult to put a price on the opportunity cost of not spending. We may have the best intention not to spend the money, but 30 years is a long time to not use that $200!
Despite the challenges of calculating the value of opportunity cost of not spending, it is useful in that it helps you identify what really matters to you. By pausing an extra few minutes before mindlessly purchasing something, you are forcing yourself to evaluate your priorities.
Is it worth it?
Instead of paying $120 a month for Sky TV, what if you could cope with just Netflix? Instead of a monthly TV bill of $120, you now have a bill of just $20. But wait…..there’s more. Not only have you saved $1,200 a year, but you now have that $1,200 to invest. Invest that money for the next 30 years and your portfolio will be $100,000 larger with the help of compound interest. $100,000 is the opportunity cost of having Sky TV for 30 years. These are the types of numbers and scenarios we should be going over in our heads before making spending decisions.
The challenge is to be able to think 30 years ahead. Common thoughts are – “I have plenty of time to save”, “Superannuation will take care of me”. “I’ll get some inheritance money”. It is hard to delay gratification when we have trouble thinking of our future selves. A tip that works for me is thinking about a comfortable retirement with the ability to travel. Just because I am thinking ahead doesn’t mean I can’t live in the present as well.
Considering the opportunity cost of not spending is not about not spending or depriving ourselves. What it does is gives us brief pause to stop and think. We are always making trade-offs with our money. Opportunity cost just helps us determine whether that trade-off is worth it by forcing us to look at the big picture. Both present and future. It is the present version of us making the decision. Future us is just as real, but not able to speak up for themselves.
Life is for enjoying. We each need to find the best balance that allows us to enjoy today, whilst still able to thrive tomorrow.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here
Do you have difficulty thinking about your future self? What tactics do you use to spend on what matters most?