Everything has an Opportunity Cost
Just as the title says, every decision has a price. Newton was right when he said everything has an equal and opposite reaction. Armed with the knowledge that everything has a cost, we are better able to make sound, rational choices ( theoretically).
Let's dive deeper.
What is the time value of money?
Before we can grasp the concept of opportunity cost, we first have to understand another related mental model - time value of money.
One of the first lessons you learn in finance is that a dollar today is worth more than a dollar tomorrow.
This is a truth that has been known by mankind since roughly 620 B.C. - 560 B.C.
“A bird in the hand is worth two in the bush” - Aesop Fables
The reasoning behind this is two fold: first you run the risk of hyperinflation taking effect and destroying the value of your two dollars tomorrow and second if you have one dollar in hand you can use that dollar to create more dollars by investing it and receiving dividends, interest payments or capital gains.
Think of your money not as cash but as a seed. You can either sow it, or you can eat it. Both actions have a price ( or opportunity cost we are getting there) it's up to you to weigh each option and then choose the best alternative.
Here is an example:
Lets use the way-back-when machine and you are now 17 years old again. Your grandmother gives you 20 dollars as a late birthday gift. You are faced with two outcomes. You can either “take the twenty dollars and take your little girlfriend out to dinner” or you can take that money and put it in a savings account.
Of course you are 17 so you take your girl out to a nice dinner, but alas that twenty dollars really wasn't “ just 20 dollars” it was worth much more.
Using this time value of money formula we can measure just how much you lost by not investing that 20 dollars in the savings account.
Here is where it gets real nerdy, so bare with me:
V = pv (1+i)n
FV = Future Value
Pv= our Payment
I = Rate of return you expect to earn
N = Number of years
Let's assume you are now 52 years old. That gives you 35 years to compound your growth. We will replace N with 35.
Now we need to figure out rate of return. To keep it simple, let's say the savings account earned 10% (I wish savings accounts really did yield this much)
I = 10.
Pmt is the payments we will receive over these 35 fives years for the sake if keeping it as clear as possible we will assume that you will not receive any payments so this value is zero.
Lastly we look at our present value. Because it is something we are giving up this number must be a negative. Or - 20. Because we are giving up this 20 to invest it in a high yielding savings account.
So it looks like this:
V = -20 (1+.10) to the 35 power
This comes out to be $562.05 talk about a full course meal. Now that you know exactly how much that 20 dollar meal is costing you in the long run you are better equipped to make a rational choice. Should you eat a 20 dollar meal today to forgo $562 dollars in a savings account in the future?
What is opportunity cost?
Time value of money is great but alone it doesn’t allow us to make rational money based decisions. We need to couple it with a little concept called
An opportunity cost represents an alternative given up when a decision is made. Like in our example above, because our 17 year old self choose to spend that 20 dollars on one dinner, we missed out on $562 35 years later. That's a $562 opportunity cost.
Breaking down opportunity cost
With that being said opportunity cost isn't always quantifiable - sometimes you can't measure it with numbers. Sometimes to put it frank - you don't give a damn about future events and what you want now is what you are going to have.
There is nothing wrong with that. Just make sure you have weighed your options and the effects of your choices before you make a decision.
A question I always ask myself, will this lead me to my personal American Dream? (link)
We all get:
Time: The 525,600 minutes of time given to you every year by God or the universe
Money: Every dollar of capital that passes through your hands
We are not given the same chances in life all we can do is maximize our time and money and hope that we are leading a life that is maximizing our dreams.
Real world example of opportunity cost.
Here is a little something about my life that you all may or may not know. I am pretty BIG into videos games. Since as long as I can remember I have had a controller in my hand. As you may know, the cost of a system, controller and games is pretty expensive. On the low end, you are looking at 250 for the system, 60 for an extra controller at 120 for a couple of games and you can't have a system without the paid gaming service to play with friends which will run you another 60 dollars a year.
Let's add all this up shall we?
That's 490 dollars and that's just to get started.
Let's now see what the opportunity cost is to get started playing video games…
If we use the same parameters, my 490 dollar habit will cost me 13,770 over the course of the rest of my working career. (35 years)
Knowing all this, the rational choice would be to not play video games and instead use said money to invest or save. The beauty in being human is that sometimes it's ok to not be rational.
I love video games, I love walking through an interactive story seeing how things unfold. That's one of the things I like to do. I have looked through the lens, weighed my options and choose to do something that gives me joy.
The point of the exercise isn't to deprive you of all the things that bring you happiness, it's to keep the things you spend your time and money on to choices that make you most happy.