A concept which was taught to me in business school, which is one of the most important out there, is called “opportunity cost”. Without understanding it, you will be far less equipped to make sound financial decisions.
What does it mean?
Opportunity cost is the concept that there are an almost infinite number of alternative decisions which could be made to the one you are making, and by making the decision you make you are consciously deciding that your decision is the best at the expense of taking a different direction. You have a “cost” to not pursuing a different decision which you need to exceed by going the route you have selected.
A simple example is when selecting a stock to purchase. Let’s say you have $1,000 to invest and you’d like to buy a large capitalization stock. There are thousands of available tickers around the world to chose from in the large cap space. They all have different levels of risk and chances of returns, dividend yield’s, product pipelines and so forth. If you decide to invest your $1,000 in Apple stock, it means that your money therefore cannot be invested in Google, or Walmart or Disney and that you “lose” the returns which you could have generated if you put your money somewhere else. Therefore, you’d better be sure, based on your due diligence and homework, that your selection of Apple has the best chance of producing a return on investment superior to that of other choices.
Why is it important?
When we make decisions in our life, we often make them based on emotional motivations. We do not always ask ourselves “what could have been?”. Understanding opportunity cost as a concept means that you will know in the back of your head that making a certain decision comes at the cost of an alternate outcome and should be weighed against those alternative outcomes.
I think it even plays into our day to day spending decisions. If I decide I want to order delivery for dinner one night, as opposed to buying groceries and making dinner myself, I have made a conscious decision that I am spending 300% more on food than I need to, and the excess of the delivery meal over the grocery bill is money that I could have instead invested in the stock market for a 10% compound return until I retire. I am 34 years old, so since I have over 30 years until I retire, that extra $30 for dinner could have been $300 in retirement.
Consider another example. When people buy into an equity position, whether its an Exchange traded fund, a stock or otherwise, sometimes the stock goes down, below what it cost to purchase. Our human instinct makes us think “I don’t want to sell at a loss – I will just wait for it to go back up”. Opportunity cost tells us that each day we wait for that losing position to regain its strength, is a day the money could have been growing in some other investment.
In other words, if your stock went down from $1,000 to $900, you now have $900 to decide what best to do with. The $100 you lost is a “sunk cost”, meaning its n the past and you can’t change it so it shouldn’t be a factor in guiding your decision making. Therefore, you should only stay in the position if you think that the stock you are in has a better chance at appreciating than other stocks. If it doesn’t, sell it and move on. It hurts to do this, from an emotional standpoint, because you have to admit to yourself that a decision you made didn’t work out. But think about it – would you rather wait a year to get the $100 back, if that is what it takes, or earn it back sooner in a better investment? Don’t let your ego guide your decision making – the best investors don’t.
Another example is saving your money in a checking account. Each year you leave it there earning 0.1% interest, you have an opportunity cost of an 8-10% return in the S&P 500. You are making a conscious decision to avoid risk of loss by leaving money in a checking account, but at the same time you are making a conscious decision not to have the opportunity for your wealth to grow. There is a cost to every decision!
The bottom line
Early in your life, the opportunity cost of spending habits is the biggest thing you need to keep in mind. When you’re 20 years old, $1 now is over $30 in retirement at an 8% compounded return. Therefore, making decisions to “live today” because “YOLO”, have a profound impact on your future wealth. Not to say you should drop everything and only focus on retirement saving, but you need to be aware of the opportunity cost of your financial decisions. Keeping this concept top of mind will allow you to stay objective and focused rather than letting your emotions lead your decision making process.