A beginner’s guide to opportunity cost

It can mean paying the mortgage, or not

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From the April 2016 issue of the magazine.

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Spend less than you earn. There’s a reason those five words (or a variation thereof) are at the top of nearly every personal finance must-do list. Because spending less than you make is the very thing that enables you to accomplish the rest of your personal finance goals. Think about it: Not too many people are able to save for their future when there’s more money coming out of their wallets than there is going in. If a young couple is spending like drunken sailors, it can be pretty tough to save a down payment for a home. (No offence to any naval personnel enjoying a cold beverage while they read this.)

Yet what seems so blatantly obvious is far too often overlooked on a daily basis. Here’s an example: If Carrie spends $1,200 on a pair of Jimmy Choo shoes when she could have spent $120 on non-Choo shoes, she’s saying goodbye to $1,080 just so she can be seen wearing Choo’s shoes. That seems loopy, at least for most of us. Especially when you consider what the $1,080 could have been used for instead. You suddenly realize that Carrie’s choice wasn’t just between Choo or non-Choo shoes. It was also a choice between Choo shoes or non-Choo shoes plus lunch with a friend, a few groceries, a bottle of wine, a mortgage pre-payment, her daughter’s swim class registration, a tank of gas in her car, an RRSP contribution and tucking $150 in her TFSA towards a dream trip to Italy. Because that’s an example of what Carrie could have done with the money instead (assuming she can’t afford the shoes plus everything else on that list).

It’s what economists refer to as opportunity cost. Actually, an economist would define opportunity cost as “the value of the best alternative foregone, in a situation where a choice needs to be made between a variety of alternatives given finite resources.” Whatever. All it really means is maximizing your hard-earned money. It’s recognizing that few money decisions are made in a vacuum and then asking yourself, “What could I do with this money instead?”

Opportunity cost is everywhere. The money you save by dining out once a week instead of thrice could be the money that puts food on your family’s table for the entire week. Commuting to work in a Chrétien-era Corolla will never be as prestigious as doing it in a brand new Big Money Waste, but look at it another way and the cash you save by driving the world’s most popular car instead of an autobahn cruiser could be the money that puts a luxurious new hot tub in your backyard. The decision to spruce up your tired kitchen with a fresh coat of paint rather than forking out a ton of dough for a complete renovation? That could potentially yield enough savings to pay for a whole new Toyota.

Savvy shoppers also understand that certain types of spending lead to, well, more spending. The aforementioned kitchen reno is a classic example. Consider that when Buddy’s old fridge breaks down, he might call around and discover it will cost $500 to have it repaired. Rather than spending half a thousand dollars on an old fridge, Buddy might decide to splash out on a new one for $1,500 instead. Sure it costs more, but the new fridge is larger, has some nicer features and comes with a warranty. Fair enough. Except that now Buddy’s stove is going to look shabby sitting across the kitchen from his shiny new fridge. Buddy finds he can get a deal if he buys a new stove along with his shiny fridge, and he can get a super deal if he picks up the matching microwave-hood at the same time. All of a sudden, Buddy’s $500 broken fridge has morphed into a $5,000 appliance upgrade or worse, a $50,000 kitchen renovation. (Trust me, it happens.)

Now, I’m not suggesting that Buddy shouldn’t buy the new fridge or even the rest of the appliances, but I am suggesting that he should stop and ask himself: “What would I do with $4,500 if I didn’t buy all new appliances?” Chances are if he was fine with the old fridge, he’ll be just as fine with it once it’s repaired. And yes, another option would be to replace the fridge now but resist the temptation to upgrade the other things. Some people are capable of that.

Opportunity cost goes the other way, too. Sometimes a rational exploration of the options presents a case for spending more. According to Dan Ariely, behavioural economist and author of The Honest Truth About Dishonesty, you should also consider the opportunity cost of your time when making spending decisions. In a recent column for the Wall Street Journal he questions the value of the time you save by parking in a pricier lot right away versus looping around the block for a cheaper deal. If your consider your free time to be worth, say, $30 an hour, it doesn’t make much sense to spend 30 minutes driving around to save a few dollars, to say nothing of the frustration felt if the search is ultimately unsuccessful and you end up paying full price.

Smart shoppers should consider their options and understand what’s at stake. Get it right and it becomes so much easier to stay true to the all-powerful personal finance mantra “spend less than you earn.”

 

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