You can’t eat your cake and have it too.
One way to help understand opportunity cost, as it relates to money, is to use time as our currency. This is because time is our scarcest resource. Once we have “spent time” doing something, we can never get that time back.
The economic definition of opportunity cost is the value of the next-best alternative forgone.
If we spend a day at the beach, that is a day we did not spend hiking in the mountains. The opportunity cost is that day we did not spend hiking in the mountains.
It works the same way with money.
Simple Examples of Opportunity Cost:
Sally keeps $10,000 in cash under her mattress. If, instead, Sally invested that $10,000 in a certificate of deposit (CD), she could earn 3% annually. The opportunity cost of Sally keeping that cash under her mattress is the 3% per year she is not earning from a CD.
Joe has $20,000 in a savings account that pays him 2% interest. He withdraws the $20,000 to buy a car with cash. He now has a car, but he no longer has $20,000 in his savings account earning 2% interest. The opportunity cost is the 2% interest he is no longer earning on the $20,000 he used to buy the car.
Why Should I Care About Opportunity Costs?
Regarding our finances, opportunity cost is the “penalty” we pay when we use money inefficiently. This “penalty” adds up over the years and has an astounding negative effect on our total potential lifetime savings.
Take the standard “Qualified (Retirement) Plan” (410K, IRA, etc). Retirement “savings” plans are laden with opportunity costs that are difficult to identify unless you’re looking for them. Fees, for example, constantly chip away, little by little, at the value of your account over a long period of time. The opportunity cost of those fees is the future long-term growth that we no longer get from that money.
By the time of retirement, taxes and fees can reduce the total potential accumulation of a 401K/IRA by half!
StackedLife’s mission is to help your family and/or business realize its full financial potential. We help identify areas where money is getting away from you in the form of opportunity cost (taxes, fees, inaccessible cash) and bring that money back under your control.