Remember the Opportunity Cost

I just wrote a A Simple Guide to Financial Freedom based on my experiences with Financial Freedom. Consider giving it a read if you are interested in this topic.

Opportunity cost is an important idea. Unfortunately, most people (myself included at times) don’t understand or consider it when buying stuff.

Say you buy a car for $50,000. The naive assumption would be to assume the car set you back $50,000. But that assumes the money would otherwise just sit idle in your bank account.

In reality, if you did not buy a car you’d have the opportunity do something else with your $50,000.

Maybe the car means you won’t go on that vacation you have been dreaming about. Or maybe you’ll have to cook a few more dinners at home.

Sure, buying a car means you won’t be able to spend the money on other things. But that isn’t the important lesson. Instead of buying stuff, what other opportunities are you missing out on?

The real opportunity cost of buying a car for $50,000 is something like $5000 a year. That assumes an 10% return on investment (historical average for the US stock market).

So your car now cost an additional $5000 a year. But it doesn’t stop there: you can also reinvest the $5000 yearly.

After 10 years of 10% compounding returns, your $50,000 car comes in at $129,687.

A 10% yearly opportunity cost means you can either have a $50,000 car today or $129,687 in ten years.

Opportunity cost is the value you forego when you pick one option over another. I think we all understand that.

But you may assume the tradeoff is between a new car or an expensive vacation. It is not. The tradeoff is between the option you are picking and all other options. If you open up the aperture a bit you may start to see a different picture.

A car purchase is a rather expensive example. But the exact same logic applies to smaller decisions as well. Every time you spend money you forego other opportunities to use that money.

Does that mean spending money buying things is always the wrong choice? Of course not. But it does mean that spending is more expensive. The sticker price does not include opportunity cost.

You can make better, more informed decisions once you understand the real cost. Maybe you buy the car, maybe you don’t — that all depends on your situation, preferences, etc. But at least you’ll make the decision with a more accurate understanding of the expense.