There is always a trade off. If I have a luxurious morning sleeping in*, then I miss the sunrise. If I live in a temperate climate then I miss out on the change of seasons. If I go for a walk*, I don’t get to snuggle up and read my book* (not the same as an audio book).
*okay, let’s be honest, I have a young kid. I don’t get to sleep in, read books, or go for leisurely strolls where I’m not chasing a small bike rider. But these are my stretch goals!
I believe that opportunity cost is one of the foundational concepts of personal finance. We all have limited resources. We have limited time. We have limited energy. And, yes, we have limited money.
Budgeting as Deliberately Managing Opportunity Cost
When we hear the word budgeting, most of us have a negative visceral reaction. In our heads it is often linked to words like deprivation and rigidity. Rather than considering a budget an instrument of hardship and duress, let’s re-frame budgeting as opportunity cost management.
There will always be limits in our lives. We cannot be in two places at once and we cannot spend the same dollar twice. (I’m not looking to be proven wrong, this isn’t meant to be a brain teaser, you get my meaning). So, if you only get to spend each dollar once, don’t you want to spend it in the way that is most important to you?
Budgeting at the Dessert Buffet
Imagine you take a child to a buffet and tell them they are allowed to choose one dessert. The child chooses a cookie and eats it. Then they come back and ask for a piece of cake. You tell them it’s too late, they already had a cookie. The kid then cries, “but I didn’t want the cookie, I really wanted the cake.” (This scenario is entirely fictional and any resemblance to experiences with my five year old are purely coincidental)
As an adult, it can be hard to find sympathy. The child was given a clear choice and made the decision. They should have planned better or thought more on their decision. But, for a small kid overwhelmed by all the goodies, their senses were overloaded and their response was more reflexive than deliberate.
The opportunity cost of eating the cookie was that the child did not get to eat the cake (or the brownie, or the pie, or the doughnut, etc.).
We have a similar, though admittedly more complex, decision to make every time we spend money. If we buy the more expensive house, then the higher mortgage will not allow for pricey vacations. If we buy the new outfit, then we cannot afford the professional haircut. But, sometimes, our decisions are a little more apples to oranges. If we keep the air conditioner running on high, we may receive an electric bill that means eating rice and beans for the month.
Having a set budget is just making intentional decisions regarding your intentions. Otherwise, like the kid with the cookie, you may find that you have to deprive yourself of the things your really wanted and come to regret decisions that were not well thought out.
Opportunity Cost in Investing
When we invest our money we are also evaluating the opportunity cost. You may be familiar with the concept of the risk-return trade-off. (For more on this topic, check out my recent blog post on risk.)This principle states that higher potential returns are associated with increased level of risk. A person more willing to risk loss may also have higher potential gains**. The opportunity to earn more money involves the cost of taking the risk and potentially losing money.
**All investing involves the possibility of loss. Taking a greater risk does not ensure a greater gain and may result in a greater loss.
When someone puts their money in a savings account it is relatively secure. Their deposit is guaranteed by FDIC and they will be able to withdraw the amount deposited plus any amount of interest earned.
Conversely, If you decide to invest in the stock market you are taking a risk** with your money. You may gain money or you may loose money. There is a chance you will gain significantly more than you would earn in the bank. There is also a chance you will walk away with substantially less money.
When you are investing in the stock market, you are giving up the opportunity of keeping your money safe. When you are putting your money in the bank, you are relinquishing the opportunity to potentially make higher returns.
The Challenge of Saving for Retirement
Saving for retirement can be one of the most challenging financial situations involving opportunity cost. When we save money for retirement we are planning for our future. We are imagining that one day we will be able to leave our job and still live comfortably. But, of course, any money that we save for the future is money we are unable to spend currently.
Most of us understand and appreciate the concept abstractly. Clearly we want to have provisions for our later years. But, the reality is that it can be hard to relate to this “future self” that we are saving for. We do not yet know who we will be in the future; what we will want, what we will be doing. This can make saving for the future feel as if you are giving the money to someone else (this unknown, future you) rather than benefiting from it yourself.
Retirement saving is even more difficult for those without much disposable income. When you already feel stretched thin, it is hard to prioritize retirement over current expenses. The abstract future can seem less significant than the present day.
Yet, we have all had situations in which we looked back on our former selves and wish we had made different financial decisions. “Why didn’t I start my 401(k) in my 20s?” “I should have purchased a house before the rates skyrocketed.” “I have lots of credit card debt and I am not sure where the money all went.” The opportunity cost of saving for retirement is having less money to spend today.
Evaluating Opportunity Cost
How do you prioritize the you who wants to retire in 20 years over the you who has bills due today? Obviously, we must pay our current expenses if we want to set ourselves up for future success. Having large debt and bad credit will not help you to retire, even if you have retirement savings.
Ultimately, all we can do is our best. We can consciously examine our priorities. We can be honest with ourselves about distinguishing our needs from our wants from our wishes. We can track and document our spending. We can establish and stick to a budget. We can choose which financial opportunities to prioritize and which to delay or release.
You may find that the joy you get from that $5 latte today outweighs the potential benefit of saving that money. Or you may realize it is just habitual spending and you are okay with the office coffee. These are decisions we all need to make for ourselves. We do all need to be cognizant that in each spending choice we make we are also making a decision to not spend the money elsewhere.