Do you remember those old television shows that gave contestants the opportunity to choose what was behind door #1 or door #2? Of course, in these shows, there was a lot of build-up about the choice. With one choice you could potentially have something of great value or something that was a bit of a disappointment. You could never go back once that choice was made. This is an example of opportunity costs and why they’re so important to you.
This is especially true with our finances. How so, you might ask?
Have you ever went to the store and contemplated about two different purchases? You had the money for either. But not both. So you chose, hoping it was the right one. But then later, when you were home, you realized you picked wrong.
That’s an oversimplification, but the concepts hold true. This is an example of a missed opportunity. And in our financial lives, we encounter the cold-hard reality of opportunity costs on a frequent basis.
What Are Opportunity Costs?
What the heck are these costs and why do they affect me? Yep, good question because whether you want to accept it or not, you’re being affected and the repercussions can be quite significant.
Ok, before we discuss how it affects you, let’s define it a bit more. Simply put, it’s a benefit you give up to get something else. It’s a trade-off. It generally means that you’ve taken option two off the table once you pick option one.
In the world of personal finance (specifically our own), we have a limited supply. Simply, we can’t have everything we want, so we have to be a bit choosy. You get your paycheck, pay the bills, hopefully save a little for that emergency fund and investing, and what’s leftover you buy something you want. But you can’t buy everything, so we sacrifice some purchases to get others we value more.
Small costs, large costs
Sometimes these choices are negligible. They don’t affect us a lot. We pick option one. Of course, we might not be able to have been able to enjoy option two, but the ramifications are short-lived. We move on and forget about it.
A simple example might be going out for a nice dinner with family or friends and spending $100. Or you could instead save that $100 for your emergency fund. On one hand, you had a good time, created some memories but that money is gone forever. However, if you had saved it, you would miss out on the experience.
One choice would give you peace of mind knowing you had funds available in case you needed it later. The other choice, some great memories. In this example, neither choice greatly impacts your life in the long run.
With some choices, however, there are significant consequences concerning opportunity costs. These are choices that we have to weigh a bit more carefully because the effects are longer lasting. It’s a bit more involved than just deciding which item we’re going to purchase and which one we’re skipping.
Again, a simple example might be our career choice. Early in life, we debated about what we wanted to be when we grew up. In most cases, once you’ve decided and committed yourself, you generally abandon the other options. Your life will forever be affected by that decision. Yeah, comforting, right?
But see how consequential that decision was? It doesn’t mean we can’t go back and change our lives, but the ramifications of our initial decision can affect us greatly.
The basis of our whole personal financial lives, our financial future is also predicated on this idea. Sometimes these decisions can ultimately mean the difference between a comfortable life in the future and one of scraping by.
How Do Opportunity Costs Affect Our Financial Future?
It can be argued that many of us don’t really consider opportunity costs when deciding what to do with our money. Overall, we just look at an item, check to see if we can afford it (or how much balance is left on our credit cards), and quickly make a decision. We don’t consider any consequences.
We might later briefly wish we could go back and change our mind but we’re busy people so we move on and usually forget about it.
I mean, seriously, when was the last time you asked yourself “what are the opportunity costs, here?” It’s not something we’re programmed to do. We’re not trained to look at what path #2 could have been like because we chose path #1.
And for most things in life, it isn’t a big deal. We would waste a lot of time and energy focusing on every decision we made. But on the larger items in life, we need to consider them. Because the ramifications are serious.
The effects of not making this a habit (at least for the more important decisions) can be seen in the elderly person stating, “I wish I invested when I was 20.” Their life has been forever changed because of that decision. Don’t believe me? Ask someone who is living on Social Security alone for their income because they have no other resources. It happens.
I know elderly people today who state they wished they could have planned better. I’m sure you know people in your life who can say the same.
Ok, Give Me Details of Opportunity Costs in My Life
Glad you asked!
1.) Choosing to save money
This is an easy one. We all have the choice to save or not save. The benefits here seem obvious, but there is a lot of data out there that states a large number of Americans don’t save. In fact, many people cannot even cover a $500 emergency.
In some cases, people may not have extra, are not able to save, and are literally living paycheck to paycheck. It’s certainly something we should strive to
eventually change our situation. But for many others, there is a massive amount of temptation to just spend all that they make. Even if they have extra every month. The resources are there but they want what they want. And they want it now. The idea of building up a savings account isn’t important enough to prioritize.
The consequences of this decision can be immediate. In life (as we know) all sorts of things happen that bounce us outside our “plans”. Extra expenses show up. They force us to deal with them. Not having money to pay for them means we put these expenses on our credit cards which puts us further into debt. As we all know, going into further debt damages our financial future.
2.) Choosing the easy road
Yep, you guessed it. Many of us are lazy. At times I throw myself into this category too. I mean, we have a lot on our plate. So at the end of the day, we deserve to relax a bit and veg, right?
Well, it’s true we should make time to relax. So this is a tricky one. There is no benefit to working your life away with no time for yourself or your family. There is also no profit in never trying to excel in anything either.
Spending your time in front of the TV all day every day has an opportunity cost. For myself, I chose to go to school, get a degree, and become an expert in my field. I reap the benefits financially from doing so. Had I chose a different path of little motivation, my finances would reflect in that decision. So, yes, our finances are affected by this opportunity cost (or loss).
3.) Identifying the opportunities in our mistakes
We all make them. No way around it. If you’re living, you’re making mistakes from time to time. It may be in your job. In your new entrepreneurial endeavor. Or perhaps in your relationship.
The trick is learning from those mistakes and growing from them. Have you ever met that person who complaints about everything? Nothing is their fault, nothing seems to go right, and they’re constantly negative? They are choosing path #1 and ignore seeing the world from a different point of view. The consequences of this decision are vast.
They miss out on that raise because they failed to go the extra mile for their boss. They never save because everything is always “taking their money.” They quit their new business because it wasn’t meant for them and they always got the short end of the stick.
I’m sure you already know that one of the greatest secrets of all entrepreneurs out there is learning from those mistakes that will inevitably happen. They adapt and try again until they have perfected it. Sometimes this may take trial and error countless times before they succeed.
Option #1 could be living paycheck to paycheck forever. Option #2 could be eventually becoming financially independent. There are tremendous opportunity costs (and benefits) in our mistakes.
4.) Choosing to invest
Ever hear the phrase, “I don’t have money to invest.” Or, “I don’t know how to invest.” I hear it all the time. And if you say this often enough it will be a self-fulfilling prophesy. Then, of course, you’ll end up being right and you will never have enough and won’t know how to put your money to work for you.
Today, more than ever, the ability to put money to work for you is the easiest it’s ever been. Go back 100 years and only the elite was able to do what you can do today. In fact, there is so much information out there and so many resources it’s easy to get inundated with the resources at your disposal!
But simple math and the general history of the stock market shows us that with a bit of time the odds are greatly in your favor of having more money (and significantly so!) in the future than you do today.
Take an average 25-year-old and have him or her put $500 in the market every month until they retire. Some years they might be poorer, others they’ll be wealthier.
Over time, however, at an average 7% return, they could be sitting on over a whopping $1,200,000!
Talk about opportunity! And if they look seriously at these opportunities before them and instead add 1% more to their contributions each year they work (because they see the opportunity cost of not doing it) they could potentially reach $2,800,000! Now talk about opportunity! All from a choice. The pessimist may argue against this possibility. Is this guaranteed? No.
But now, imagine not making this choice, by not considering this opportunity. How much money will you have? Good question, right? What is the correct answer? You tell me. There are plenty of people out there right now who are considered living in poverty because of this decision.
5.) The time cost
Time is a commodity too. This can (and usually does) have more value than money. Spending the extra time, devoting yourself to larger decisions can greatly impact your future. Some decisions take time to develop, plan, and carry out. Others, not so much.
Remember when I talked about vegging out on the couch vs being more productive? Yes, this comes at a cost. That’s why so many people opt for the lazier
route. It’s easier and they value the “enjoyment” factor right now of that decision. There is not as much work involved.
However, putting in the effort today may save you in labor (and time) later. It can also be better financially. Take, for instance, the person who learns about developing passive income. Although there may be lots of mistakes along the road, costing them more time upfront (and a massive amount of work initially), the benefits can be wonderful.
Later they are able to enjoy years (if not decades) of income from that initial up-front work. So, yep, this time cost can affect your finances too.
6.) The cost of inaction
Not doing anything is a decision. I don’t think I have to explain the opportunities lost with inaction.
Things That Can Hurt Your Opportunities
1.) Credit cards
Yes, you’ve guessed it. We’re back to the ubiquitous credit card. Now, don’t get me wrong. Credit cards can be great: they’re convenient, and they can offer some great rewards. But if you misuse them (you’ll probably agree with me that many people do) they can weigh heavily on your opportunity costs (make them much worse than they need to be).
Credit cards can, however, temporarily replace the lost opportunity. What? That sounds like a positive thing, you say. Normally, when we use only cash (think dollar bills in your hand) the moment you buy something, that money leaves your hand. No more left until you get paid. You choose opportunity #1 and left #2 out in the cold. The opportunities were limited. The choice was one or the other. But often not both.
Credit cards make it possible to have both options. At least until you run out of credit. And this is not a good thing. Meaning, you can pay for what you want with option #1 and add #2 because, well, you just wanted it, often regardless of the consequences. The bottom line: you borrowed someone else’s money and they’ll want it back.
So, this money has to be paid back. With interest. A lot of interest. Do this long enough, you max out your card and you’re in the hole. Then all future choices are out the window. No option #1 or #2 later.
Then, where is that money you wanted to invest for your future? Gone to your credit card vendor. That money to fix your car? Well, probably going to have to add it to the credit card. Money to live on when you’re older? Well, think a bit on that one and let me know if you’ll have the funds…
2.) Impatience
This goes hand in hand with the credit card idea above. Impatience makes you want your cake and eat it too (well, who doesn’t right?). But it will tempt you to covet all of your wants at the expense of credit card debt, car auto loans, student loans, and excessive mortgage loans.
This eventually takes all your other opportunities off the table, no more discussion.
How To Consider Then Benefit From Opportunity Costs
Ok, now that we realize this is a real thing, how best to use it to our advantage?
1.) Realize they’re a part of our everyday life
If you think about it, we have these opportunities in almost everything we do. Every time you make a choice you’re weighing one option against another. We inherently do them without giving them much consideration. You can work out at the gym or sit on the couch. There are results to this decision. You can eat well or not. You can play video games or work on a business. So, accept that you’re a part of this whether you like it or not.
2.) There are opportunities all around us
I would argue that there are certainly times where our paths are forced onto us. But mostly our destiny is in our control to some degree. So in everything we have opportunity.
I know people who started out with very little but have turned their lives around, now working in a job others would be envious of. However, when it comes to our finances, most would probably tell you that they’ve got it figured out. They know what works for them. And that they’re comfortable with it. They’re content.
But that comfort results in inaction. It accepts the status quo. The problem is, there are a vast number of people who are financially unprepared for the future. The status quo won’t save them. Their working years are generally the only time they can change their destiny.
By recognizing the opportunities available to them, they could begin to learn about money and good financial decisions. They could choose door #2 instead of the path they’re currently on.
3.) Think tactically about your opportunities
Ask yourself, “What could this do for me instead?” Meaning, consider the costs of your decision and how could you change an outcome for a positive instead.
Remember, whatever you spend today cannot be used for something better in your future. That is, unless you invest those dollars in something that will benefit you later in the form of dividends or other financial return. Will this choice give me more options? Will this choice give me more time in my life later on?
Train yourself to ask what other options are available to you and your money? Recognize that there are opportunities out there if you open your eyes.
Granted, many of us won’t think this way about everything. Obviously we’re not weighing the costs of everything otherwise we would be bogged down in the minutia. But when it comes to anything concerning a larger amount of your money or your time, think twice about it.
For instance, if something is going to cost over $500 bucks, really think what that money can instead do for you. Sometimes it’s ok to buy that super cool sofa table, but other times that money may do so much more for you. That decision is obviously yours to make, but at least now you have options to consider.
Seize Your Opportunity
Opportunity costs affect us all. There is always some sort of cost when making one decision over another, especially concerning our money. We can either spend our money or save our cash. However, you’ve probably never really been consciously aware that you’re even being affected. Which means you were unaware of the long-term effects they can have.
Most of the time these are minor decisions we consider in seconds and are generally happy with the outcome.
Other times, we make choices that affect our future without even being aware of it, sometimes with serious consequences. You don’t want to end up being an older person regretting opportunities that you may have had if you’d only recognized them. We all only have one life to live and a limited time to prepare for our future.
However, now you’re not only aware but are equipped with the knowledge. You can take advantage of opportunity costs. So, take that pause for 10 seconds and think about the opportunities around you.
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