We make financial choices constantly. Dine out or save that extra money for retirement. Save in our employer’s retirement plan or hit the latest movie. These are opportunity costs that add up. Here’s why.
We buy something or buy nothing. Sometimes we walk rather than drive, pack a lunch rather than eat out and save money rather than spend it. These opportunity costs we give up to take advantage of another opportunity. Alternatives cost in terms of benefits you receive by taking an alternative action.
Let’s take an investment example. Say you invest in a stock that returns just 2% over the year. You place your money in the stock and give up a shot at a low-risk, high-grade corporate bond yielding 6%. Your opportunity costs you 4% in returns.
You don’t have to play the market to see opportunity costs. When you choose to spend today, you miss the opportunity for your money to grow and compound over time toward a nest egg. Your opportunity costs sacrifice a nicer retirement, for instance, for gratification today.
Compound interest, when supported by clear figures, easily proves its value and staggers most people. Your money grows, and the longer you hold it the better the growth. For example, do you earn more in a job paying $1,000 a day for 35 days or a job paying one cent the first day and doubling that every day for 35 days?
The math shows that after 25 days a penny a day out-earns $1,000 a day by more than $140,000. No legitimate interest is 100%, as is the case here, but the exaggeration proves the point.
Eating lunch out every day rather than brown-bagging it potentially gives up the opportunity to save more for retirement, your children’s college tuition or another goal you want but just can’t, you tell yourself, afford. You can’t afford to save for retirement but can afford $100 for your smartphone plan, $75 for cable TV and about $20 for daily coffees and lunches.
You prioritize what you can afford and think you can afford, and not alone. “Where do you draw the line,” asks a commenter on the personal finance board of Reddit.com. “How do you find that balance between putting money aside for your future and enjoying your life right now, cognizant … that we have no idea what the future holds?
“You always hear people say that you should contribute everything you can to employer-matched 401(k)s. I worked real hard to get to the salary I make now. Now, I’m just supposed to put X% aside, automatically? What if I never see that money again? It’s a scary thought to me, knowing how much I have to sacrifice from my joy right now … to do that.”
Saving is a little like travel: 30 minutes saved on the front of the trip becomes a few hours saved on the other end. Think about your opportunity costs and what you give up when choosing alternatives. What can we give up today to afford our future?
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Sterling Raskie, MSFS, MBA, CFP, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is an adjunct professor teaching courses in math, finance, insurance and investments. His blog is Getting Your Financial Ducks in a Row, where he writes regularly about investments, retirement savings and financial planning.
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