One of the standard methods of assessing the desirability of a particular financial decision is to evaluate the benefits and associated costs. But 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 for 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.
At this abstract level, every financial decision has an opportunity cost, because choosing one financial transaction means sacrificing the opportunity to select another one. But economists often take the idea of opportunity cost one step further by considering what would have happened if you hadn’t spent the money at all, but just left it to accumulate additional earnings. For example:
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.
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 decision for the $10,000 if it wasn’t used to buy the 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.
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. 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 an imaginary calculation of opportunity cost provides a more accurate picture of the real economic cost of a financial decision.
From a personal planning 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 investment 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 a better chance of succeeding. When you apply the opportunity cost concept to typical financial decisions, it may dramatically change your assessment of the transaction.
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 taxes, 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. But what would 20 years of $2,500 payments be worth if they had been invested? Using our “reasonable” (but arbitrary) 5% annual rate of return, our calculation of the real cost of property taxes is $86,798 (see Fig. 1a).
This number might be imaginary, but even in its hypothetical form, it more accurately represents the true cost of the 20-year transaction. In this instance, the opportunity cost from property taxes has cut the profit in half. (By the way, if the rate of return used for calculating opportunity cost was 10% instead of 5%, the resulting calculation, $157,506, would exceed the $150,000 “profit” on the sale of the house – see Fig.1b.)
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, knowing that doing so will pay off with big numbers at a later date. But 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. To illustrate:
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). But remember how much opportunity cost doubled when you changed the opportunity cost factor from 5% to 10% in the property tax example? Watch what happens when you make the same change, but compound the opportunity cost over 50 years instead of 20 (see Fig.2b). The opportunity cost over 50 years is $507,000, almost eight times greater than it was at 5%! Using this “imaginary” number, the implication is that the decision to own $500,000 of “cheap” term life insurance (which you will probably eventually surrender) has the long-term potential to cost more than the life insurance benefit you “rented” for 20 years, then forfeited. The only way to “win” financially is to die during the 20-year term when the insurance is in force. 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 “mistakes” made early in life are the most costly, simply because the lost opportunity costs that result accrue against you for the longest time. A decision that results in an additional $1,000 of financial cost 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 barely an overview of opportunity costs, but hopefully it’s enough to convince you that opportunity cost is a legitimate factor in evaluating the desirability of different financial actions. While determining a “reasonable” number for calculating opportunity cost is certainly a subjective decision, you have the privilege of deciding what factor reflects your financial perspective. And plans that consider opportunity costs – even with arbitrary numbers – are more likely to be plans that better reflect financial reality, and have a better chance of succeeding.
- HAVE YOU INTEGRATED OPPORTUNITY COST CONCEPTS IN YOUR FINANCIAL PROGRAM?
- DO YOU KNOW HOW TO EVALUATE THE OPPORTUNITY COSTS OF YOUR FINANCIAL DECISIONS?