LinkedIn Author Jane Barratt shows you how to incorporate the idea of opportunity cost into your everyday life, learning how to optimize for growth vs. consumption.
- Opportunity cost, like compound interest and dental hygiene, is something that should be taught at a very early age. At its very core is the idea that something needs to be given up in order to achieve something else, like when you sacrifice your time in order to buy things. For example, let's say I want to buy a new couch for $650 and I earn $45 an hour. That's 14 hours I need to work to pay for it. Is that couch really worth two days of my working life, given all the other things I could buy? But that example's way too simple.
Most people have bills to pay and only a small part of their salary aside for household purchases. So let's say in my budget that's 10%. That means now I have to work 140 hours to get that couch, almost a whole month. Another element of opportunity cost is that by committing my time and money to that couch, I need to forgo other household purchases and only buy the new mattress I need after the couch is fully paid for. But, I mean, who really buys things one at a time? That's what credit cards are for, right? So let's say I put the couch on my credit card, for which I'm paying the U.S. average 13% interest.
So that's an extra two hours that I need to work to cover that. The true nature of opportunity cost really kicks in with quite a radical idea. What if I don't buy the couch at all and take that $650 and put it into savings, or even better, invest it? And that's the true sense of financial opportunity cost. Prioritize investing and growing money over spending it. That couch money, invested at standard market returns, could be worth more than $1,300 in 10 years.
And it's not just about savings and investing. If you're committed to giving to charity, don't make it additive. See where you can cut expenses and give that away. Being honest with yourself and with how you allocate your money is critically important. You can't say you save money by renting if you're not putting the difference between your rent and total cost of ownership of a home into your savings and investments. Opportunity cost is a simple concept in theory, but one that can be enormously powerful in practice.
So the next time you're assessing something from a monetary perspective, add the opportunity cost lens and see if your evaluation changes. And remember, as Warren Buffett says, "Unless you can figure out how to make money while you sleep "you'll work until you die." That's the ultimate in opportunity cost.
- Identify the class of investments with the highest risk.
- Explain the type of attitude to maintain in regards to risk.
- Recall the information typically not included in an account statement.
- Calculate the percentage of a management fee when provided the number of basis points.
- Recognize the types of assets to unload during a downturn.