One of the most typical methods of assessing the desirability of a particular financial decision is to evaluate the “benefits and associated costs.” Yet what is the true cost of a financial decision? Even in the simplest transaction, the cost isn’t just the amount that leaves your checking account. You must also consider the opportunity cost.
University of Washington professor Paul Heyne (1931-2000) was the author of a noted introductory level economics textbook titled The Economic Way of Thinking. Heyne defined opportunity cost as “the value of sacrificed opportunities.”
Money spent on one item is money that can’t be used to buy something else. If you choose to spend $10 on a pizza, that’s $10 that can’t be spent on something else, like gas in the car. And, what if you spend $10 on a pizza and then learn that another pizza shop is offering 2-for-1 deals.
In theory, this is a practical way of prioritizing financial decisions. Yet few typical financial planners will actually account for opportunity cost. Even fewer know how to calculate it.
Table Of Contents
- Using Opportunity Cost Calculations
- The Dark Side Of Opportunity Costs
- Are Your Financial Decisions Taking Opportunity Costs Into Account?
At this abstract level, every financial decision has an opportunity cost, because choosing one financial transaction means sacrificing the opportunity to select another one. And yet, this is the place where most planners will stop. To get the whole picture of opportunity cost, you must consider what happens if you hadn’t spent the money at all.
A used car purchased for $10,000 that provides transportation for 5 years doesn’t simply generate an opportunity cost of $10,000 that can’t be spent on something else today. Instead, opportunity cost includes what the $10,000 would have been worth five years later if it hadn’t been used to buy the car.
Using an annual rate of return of 5%, the “real cost” of the $10,000 purchase would be $12,762—even if you paid cash for the vehicle. This doesn’t even factor in that the car’s value depreciates.
Now, let’s say you bought a new car for $40,000. On average, a car will depreciate in value at a rate of 20% annually. Hence, after 5 years the same car is only worth $16,000. Talk about a depleting asset.
If you understand the basic concept of opportunity cost, the previous example should prompt a question: Why was the opportunity cost calculated at 5%?
The answer: The decision to use 5% was arbitrary.
It represents a hypothetical investment/savings decision for the $10,000 if it wasn’t used to buy the used car. Depending on one’s perspective, the opportunity cost could have been calculated at 1% or 100%, or any other number. So even though opportunity cost is real, calculating it requires some imagination.
Why More People Don’t Use Opportunity Cost
This ambiguity in the calculation of opportunity costs makes some people edgy. If opportunity cost can be calculated at any rate one chooses, it makes any decision as cheap or expensive as you want it to be. In theory.
For economists (and business analysts who use opportunity cost as part of their decision-making), a key part of their cost evaluation is arriving at a “reasonable” number used for calculation.
This reasonable number could be an average from a stock index, the current rate for Treasury bills, an interest rate from the local bank – or some other number that seems relevant to their situation. This means “reasonable” opportunity cost calculations are still imaginary and hypothetical. However, even a hypothetical calculation of opportunity cost provides a more accurate picture of the real economic cost of a financial decision.
We often use 3%-5% because that represents a historically supported earnings rate of a whole life insurance policy. So we weigh our decisions against what we could have earned had we saved into a policy.
From a financial strategy perspective, the hypothetical component in calculating opportunity cost can be seen as an advantage in that individuals have the freedom to assess their true costs based on their unique circumstances and perceptions.
If you think your opportunity cost should be calculated at 3% based on the alternatives you might pursue, that’s great. If you think the number should be 15%, that’s okay too. The number isn’t as important as developing an “economic way of thinking” that takes opportunity cost into consideration.
Financial decisions that consider opportunity costs are decisions that more closely reflect financial reality, and have an even better chance of succeeding. This is especially important if you want help from a financial advisor, or you’re researching personal finance topics. And when you apply the opportunity cost concept to your personal financial decisions, it may dramatically change your assessment of the transaction.In other words: is your present decision worth your future opportunity? Only you can decide, yet it’s important you be armed with all the facts to do so.
Using Opportunity Cost Calculations
Some of the best applications of opportunity cost can be found in assessing “extra” costs that often accompany some financial decisions. For example, the decision to buy a home also includes assuming additional costs like property taxes, closing costs, utilities, HOA dues, mortgage and homeowners insurance, and maintenance.
Many people don’t calculate these ongoing ancillary costs, and even those that do probably will not calculate the opportunity costs that result. Consider this scenario:
If you bought a home 20 years ago for $100,000 and sold it today for $250,000, simple math shows a gain of $150,000 over the past 20 years.
Suppose also the annual property tax bill was $2,500 for the past 20 years. 20 x $2,500 = $50,000, which are house-related expenses that should be subtracted from your profit calculation. However, what would 20 years of $2,500 payments be worth if they had been saved into a whole life insurance policy? Using our “reasonable” 5% annual rate of return, our calculation of the real cost of property taxes is $86,798 (see Fig. 1a).
This number might feel “imaginary”, and yet even in its hypothetical form, it more accurately represents the true cost of the 20-year transaction. In this instance, the opportunity cost of property taxes has cut the profit in half.
This doesn’t, however, mean that home ownership was a poor decision. It is yet another way of assessing your financial picture more accurately, so that you can make optimal decisions.
Other places where opportunity cost calculations can be of value include determining the real cost of term life insurance, the true rate of return on taxable investment products, and decisions about when to pay cash and when to borrow.
The Dark Side Of Opportunity Costs
Most of us have encountered a concept dubbed the “Magic of Compound Interest,” which is an illustration of how small amounts can balloon into enormous numbers over time through simple compounding.
The Magic of Compound Interest is a way to encourage you to invest and save on a long-term basis. Most people use this method when considering a 5-year or 10-year certificate of deposit (CD). Ideally, the longer the investment sits locked away and accruing compound interest, the more it will pay off with big numbers at a later date. A $100,000 CD that’s accruing 5% interest will gain $5,000 or 0.05%.
The ending result is you now have $105,000 when your CD matures and if you don’t choose a rollover. Even so, understanding opportunity costs reveals a dark side to the Magic of Compound Interest.Some opportunity costs just keep adding up, even after you stop the transaction. This means small financial costs incurred today can grow to enormous losses over time because compounding is working against you instead of for you.
When you buy $500,000 of 20-year term insurance at age 35 for annual premiums of $420, then discontinue premium payments when the term ends, your opportunity costs still keep accruing, for the rest of your life.
If you live to age 85, the true cost of the $8,400 spent on life insurance protection you had for 20 years is over $65,000—using an opportunity rate of 5% (see Fig. 2a).
And what happens if we calculate that cost at 10%? The implication is that the decision to own $500,000 of “cheap” term life insurance (which you will most likely surrender if you don’t use it) has the long-term potential to cost more than the life insurance benefit you “rented” for 20 years, then forfeit. (See Fig. 2b.)
The only way to “win” financially is to die during the 20-year term when the insurance is in force. Why? The policy has a set expiration date, and when it expires there’s no cash value. An even better alternative is a whole life policy with a cash value you can borrow against. While term life insurance has a reputation for being low cost, this type of economic evaluation of opportunity costs might alter your perspective—regardless of the factor you use for calculation.
One of the most sobering thoughts that comes from having an awareness of opportunity cost is that financial decisions made early in life are the most costly, simply because the lost opportunity costs accrue over a longer time frame.
A decision that results in an additional cost of $1,000 at age 25 could theoretically compound against you for 50 or 60 years, while the same mistake at 65 wouldn’t do nearly as much damage.
This perspective puts a high premium on becoming financially efficient as soon as possible. Otherwise, you run the risk of opportunity cost compounding against you.
Are Your Financial Decisions Taking Opportunity Costs Into Account?
This discussion is a brief overview of opportunity costs. And yet, hopefully, it’s enough to convince you that opportunity cost is a legitimate factor in evaluating your financial decisions and the desirability of different decisions.
Financial strategies that consider opportunity costs—even with arbitrary numbers—are more likely to be strategies that reflect financial reality and have a greater chance of succeeding.