When we make spending choices, we rarely think beyond the moment. However, whenever we spend our money on something now, we are giving something up later. This is what's known as opportunity cost. Understanding opportunity cost is one of the keys to making better financial decisions.
"The idea behind opportunity cost is that the money you spend now on a consumer product could have been invested and put to work on your behalf," says Kevin Stewart, the founder of Calculate My Wealth, an app designed to help you quickly see what your money could be doing for you over time.
The TRUE Cost of a Pair of $200 Sneakers
Stewart relates the story of his nephew, who won $200 in a school raffle. The excited 8-year-old knew exactly what he wanted: A pair of expensive basketball shoes. He spent the money on the sneakers, but Stewart wondered what that $200 could have turned into if invested. After running the numbers, Stewart discovered that, assuming a 10% annualized return for stocks, that $200 would turn into $74,947 after 60 years of compound interest.
"My nephew thinks he has a nice new pair of $200 shoes," Stewart says. "I think he has a pair of $75,000 shoes."
This is how opportunity cost works. Every time you spend your money, you are making a statement about what is important to you. You're also making a choice about your future. The money you spend now might have contributed significantly to your future wealth with the right investments. It doesn't seem like a big deal to spend a few hundred dollars on a consumer item today, but when you consider what that money could do on your behalf after two or three decades of earning returns, it suddenly seems a little more important.
Decide What's Worth the Cost
"Considering opportunity cost forces you to really think about your values, and what you want to do with your money," says Stewart.
He points out that it's impractical to assume that you'll never use your money for anything other than investing and building long-term wealth. Not only do you need to cover the necessities of life, but it's also important to actually live a little.
Opportunity cost should be used to help you identify what really matters to you, and cause you to pause before mindlessly spending on something that won't truly enrich your life in some way. What if, instead of spending $150 a month on cable, you paid for Netflix and Hulu. Now, instead of a monthly bill of $150 for TV entertainment, you spend $15.98. That's a savings of $134.02. Invest that money every month for the next 25 years, until you are ready to retire. Your portfolio will be $176,774 larger with the help of compound interest. No, you won't have access to all the channels, but you're still likely to access enough entertainment for your purposes, and you'll be earning interest over time, rather than spending $40,206 extra over the course of 25 years.
These types of choices can be made on a regular basis. When you think about what today's spending truly costs you in the long run -- translate those earnings into a more comfortable home or the ability to travel during retirement -- it becomes easier to make better decisions with your money.
But don't let the idea of amassing huge wealth stop you from enjoying the things that really matter to you. "I'm not saying you should stop spending on things you don't need," insists Stewart. "You should stop spending on things that don't matter to you."
It's true that I could put away more money in my own retirement portfolio if I traveled less. However, the trips I take with my son provide us with priceless experiences and memories, and bind us together as a family. I don't consider it a waste to spend money on music lessons for my son, or on other enrichment activities that benefit him. There's no point to having money if you don't use it to better your life.
"The idea behind opportunity cost is to force you to stop and think," says Stewart. "You always make tradeoffs with your money. Opportunity cost helps you determine whether or not that tradeoff is worth it."